Market 101 – Trading

As mentioned in the previous section, trading an OTCQX, OTCQB or OTC Pink security is comparable to trading a security on NYSE or NASDAQ. Investors may buy and sell securities through the institutional, online or retail broker-dealer of their choice.

Similar to the U.S. stocks exchanges, security prices respond to the supply and demand in the marketplace. Investors desire to buy and sell securities at certain prices and broker-dealers provide liquidity by trading for their own account, matching orders internally or publishing quotes and executing with external broker-dealers. The number of orders, the volume (e.g. share size), the timing of buy and sell orders, and the availability of information determines how prices will move for a particular security.

A step-by-step explanation is the best way to illustrate the trading process. The example below is tailored for individual investors, although many of the same principles apply to institutional investors.

  1. Investor Selects a Broker-Dealer – In order to execute a trade, an investor must select a FINRA-registered broker-dealer (or multiple FINRA member broker-dealers).
  2. Investor Makes an Investment Decision – All investment decisions should be based on thorough research on the company and security. For securities that trade on the OTCQX, OTCQB and OTC Pink marketplaces, investors can use www.otcmarkets.com to access the information companies have provided, including trade data and company news and financials to help facilitate an investment decision.
  3. Investor Defines the Order – Investors define the order they wish the broker-dealer to execute. There are two main order types: the Limit Order and the Market Order.
    • Limit Orders allow investors to specify the exact price they are willing to accept for a buy or sell order. While Limit Orders are designed to offer more price protection for investors, a Limit Order may not be executed if the price of the security does not reach the price stated in the Limit Order
    • Market Orders direct the broker-dealer to immediately execute either a buy or sell order at the current ‘market price’ – the best bid or offer
    Investors must decide whether price (Limit Order) or timing/immediacy (Market Order) is more important to them.
  4. Broker-Dealer Executes the Order – Once a broker-dealer receives an order, it often goes through the following decisions as part of the trading process:
    • Execute Trade Internally – Broker-dealers will typically first determine if they can or choose to execute the trade internally. Internal executions occur if they can ‘match’ (same prices for a buy and sell order) Limit Orders or if they choose to trade for their own account. If they are trading for their own account, they must give investors their limit order price or the NBBO (National Best Bid or Offer) as defined by an Inter-dealer Quotation Systems (OTC Link® ATS/FINRA OTCBB) at that point in time. This rule is known as Best Execution and is among the regulations discussed in Part 3 - Regulation
    • Trade Marketable Order Externally - If the broker-dealer cannot, or chooses not to, execute the trade internally, he/she must attempt to execute the trade with another broker-dealer. OTC Link® ATS provides trading and messaging capabilities, and therefore, facilitates the process of ascertaining whether the order is marketable. Marketable orders are orders where the price specified can immediately be executed in the market. Market Orders are, by definition, marketable. Limit Orders are marketable if the limit price is less than or equal to the bid price (for sell orders) or greater than or equal to the ask price (for buy orders) (i.e. execution is at a price better than or equal to the limit price). For example, a customer’s Limit Order to buy security XYZ for $30 will only be marketable if the offer/ask price is $30 or less. If the offer price is $30.01 or greater, then the limit order is not marketable and will not be executed. If the order is marketable, the broker-dealer may utilize OTC Link® ATS to negotiate a trade electronically with a specific broker-dealer (or group of broker-dealers) or may contact the broker-dealers by other means of communication
    • Create/Edit Quote on Inter-dealer Quotation System – If the order is not marketable, the broker-dealer may create or edit its existing quote on an Inter-dealer Quotation System (e.g. OTC Link® ATS) to reflect a new price or size. The quote communicates the price at which a broker-dealer is willing to buy or sell. Broker-dealers are only required to update their quote if the price of the order is equal or superior to their existing quote (See FINRA Rule 6460 and Part 3 - Regulation). In many cases, a broker-dealer quote is the aggregation of a number of customer orders. Often, at a client’s request, broker-dealers will not display the entire order because this information may cause the other broker-dealers to move their prices resulting in inferior or no execution
    • Trade Non-Marketable Order Externally - Once a broker-dealer has a quote posted on OTC Link® ATS, they may receive a trade message via OTC Link® ATS from another broker-dealer; as the market changes, a broker-dealer with a standing quote may also initiate a trade message electronically. At that point the broker-dealer may accept, decline or counter (send a different price or size) the offer to trade . The broker-dealers then negotiate trade price/size, one of the main differences between a trading a security off-exchange and trading a listed security. There is no central system that matches/executes orders for off-exchange traded securities – all trades are agreed upon directly between the broker-dealers. OTC Markets Group’s trading platform, OTC Link® ATS, facilitates the speed at which trades are negotiated. Broker-dealers are liable for their quote price and size, and those firms that decline liable orders are subject to penalties from FINRA. While broker-dealers may communicate by phone, one of the benefits of OTC Link® ATS is the ability for broker-dealers to trade and message electronically, creating a more efficient trading process
  5. Broker-Dealer Reports, Clears and Settles Trade – Once broker-dealers accept an offer to trade through OTC Link® ATS or through another means of communication, they must report, clear, and settle the trade. Part of this process is the confirmation of the trade with the investor; however, the trade will not be complete until final settlement (the delivery of funds by the buyer and the delivery of securities by the seller), which, for equity securities is generally three business days after the trade date (T+3). While OTC Markets Group’s products and services facilitate the reporting, clearing, and settlement process by transmitting trade data to the broker-dealers, all three functions are the responsibility of the executing broker-dealers
    • Reporting – Broker-dealers are required to report their trades to FINRA within 30 seconds of the execution. This information is then disseminated by FINRA to the market. OTC Markets Group offers this ‘real-time’ trade data within a number of its products OTC Dealer, OTCQuote.com, OTCIQ.com). All other trade information is on a 15 minute delayed basis
    • Clearing and Settlement – For equity transactions in OTCQX, OTCQB and OTC Pink, clearing and settling, the matching of trades and the movement of money and securities, is often handled by third-party firms for the broker-dealers

The explanation of the trading process has been abridged to describe in a more streamlined manner how securities efficiently trade on OTC Link® ATS and in excess of $600 million every day. For a more detailed analysis of the trading process, please contact our Trading Services department.


Additional Concepts

Further knowledge on the structure of the market is important to understanding the market for a security. The subjects listed below only touch on high-level concepts of trading techniques, strategies and market structure. To find out more information, please see our Whitepapers.

Liquidity

From a trading perspective, liquidity is the ability of a security to be bought or sold without causing a significant movement in the price of the security. Liquid securities may be bought and sold in large numbers without a dramatic movement in the price of the security. The opposite is true for illiquid securities. Liquidity depends on a number of forces, including supply and demand, price transparency, trading history, market venue, market participants and freely tradable shares (public float).

The Spread

“The Spread” is a term that applies to all markets and represents the difference between the highest bid price and the lowest ask price. For example, if “the bid” is $10.00 and “the ask” is $11.00, then the spread is $1.00. The spread is one of the ways that broker-dealers, specifically market makers (a type of broker-dealer that provides liquidity by quoting and trading both sides of the market), make money. In an ideal world, broker-dealers want to buy at the bid price and sell at the ask price. This scenario allows them to have very little risk and make “the spread” on each share transacted. Unfortunately for market makers, this scenario is not extremely common due to price volatility – movements in the price of a security.

Volatility makes it possible for broker-dealers to lose money, providing liquidity to both sides of the market. Security purchases at the bid price can become unprofitable if the price quickly or significantly moves lower. Therefore, spreads tend to be wider (larger) in very volatile or illiquid (not easily tradable) securities.

Spreads are often a function of the amount of information available in a security. This information may come in the form of past trading data, news or company financials. If very little information is available in a security, spreads may be very large because the broker-dealer does not want to be caught off guard by a better-informed investor. Conversely, active securities with current disclosure tend to have tighter spreads because broker-dealers believe they have sufficient knowledge of the company and the security to buy and sell with confidence. Investors are wise to pay attention to the spread of any security, and in particular, to those where the issuing company does not provide quality disclosure.

Short Selling

Short selling is a trading strategy where an investor, believing that a security is over-valued, borrows (from a broker-dealer or institutional investor) and sells a security and then repurchases and returns (to the broker-dealer or institutional investor) the security at a lower price. The difference between the sale price and the purchase price is the investor’s profit. Short selling is a valid trading strategy; however, there are two important points that investors must remember:

  • Short selling carries with it unlimited risk because the purchase price of a security can rise to any price point. Conversely, long investors (buyers) may only lose the amount invested – if, for example, the security price drops to zero
  • Short sellers are subject to price manipulation schemes – or short squeezes. In a short squeeze, traders believing that there are a lot of short sellers begin buying shares to force the price and the short seller’s losses higher. These traders hope that the short sellers will be forced to buy pushing the price even higher at which point they can sell their shares at a profit. Short squeezes are easier to execute in illiquid securities

See how regulation affects market structure and processes in Part 3 - Regulation.

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