Liquidity Risk of OTC Stocks

by Slav Fedorov, studioD

Liquidity means how easily you can sell a stock without the transaction affecting the current stock price. Liquidity risk is high if there are no buyers for your shares at the current price, and you have to wait a long time to sell your shares, or have to accept a lower price. Liquidity risk is high in the over-the-counter market because of the way it’s structured.

Trading Volume

Trading volume is the number of shares traded daily. The higher the volume, the more liquid a stock is. You need an active market to be able to sell your shares easily for a fair price. Trading volume shows how much interest there is in a particular stock. If nobody else is interested, it’s hard to get a fair price for your shares.

Small Obscure Issues

To be listed on an exchange, a stock must meet the minimum exchange listing requirements and the company must pay exchange listing fees. It is easier and cheaper for small obscure companies to get their stock traded in the over-the-counter market. When a company fails to maintain minimum listing requirements, its stock is delisted from the exchange, but can still trade in the OTC market. This often happens after a stock has declined significantly on poor financial results or following some really bad news, such as accounting fraud. Investors have little interest in such stocks because of their poor performance and high potential for price manipulation.

Price Manipulation

You can always sell a stock if the price is right. The OTC market consists of a network of dealers who trade in specific issues. They will buy from you as long as they can resell your shares for a profit by low-balling you, or because your alternative would be to wait a long time for a legitimate buyer.

"Pump and Dump"

Illiquid lower-priced issues are easy to manipulate. For example, a skillful operator accumulates all the shares of XYZ he can get at 10 to 20 cents a share, and begins to “pump” the stock by circulating glorified online reports, issuing “strong buy” recommendations through bogus sites, and posting bullish messages on stock message boards. Naïve investors believe the hype and begin to buy the stock. XYZ begins to rapidly advance in price on increased demand, reaching $2 a share in a matter of weeks. The flurry of buying creates liquidity in the stock. Then the “dump” starts: the manipulator begins to sell his shares into the strength and the price suddenly drops. Liquidity dries up. If you bought during the hype when XYZ was zooming and now want out because it’s falling, there are few takers — again — and you have to accept a much lower price if you want to get back at least some of your cash.

About the Author

Based in San Diego, Slav Fedorov started writing for online publications in 2007, specializing in stock trading. He has worked in financial services for more than 20 years, serving as a banker, financial planner and stockbroker. Now working as a professional trader, Fedorov is also the founder of a stock-picking company.

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