What Makes the Over-the-Counter Market Different From the NASDAQ or the New York Stock Exchange?

To some extent, a share of stock is a share of stock. It represents a partial stake in a company, it can be bought or sold on the market, and it generally gives you the ability to vote on corporate governance decisions and the potential to earn dividends if the company pays them out. But while some high-profile stocks are bought and sold on the famous markets like the New York Stock Exchange and the Nasdaq exchange, others are sold on the over-the-counter market, an avenue with fewer restrictions.

Investing in Stock

When you buy a share of stock in a company, you're essentially buying a small stake in the company. Generally, you're hoping to hold on to the stock as it increases in value to sell later at a profit. You may also benefit if the company pays out a dividend, meaning a share of money distributed proportionally to how many shares stockholders have, or if the company chooses to buy back shares.

You can sometimes purchase stock directly from the company that issues it, but you usually buy through a stock brokerage, a company that usually charges a commission fee in exchange for managing your purchase and ownership of the stock. You can track stock values online through your brokerage or the financial press and buy and sell based on changing prices and news about companies you're investing in.

OTC vs. Nasdaq and NYSE

Many high-profile companies, and even some lesser-known ones, list their stocks on big-name exchanges like the New York Stock Exchange and Nasdaq. These exchanges have minimum requirements for stock prices, total market capitalization and disclosure by the companies they list.

If a company isn't listed on a big exchange, you may still be able to buy and sell its stock using the over-the-counter, or OTC, system. In that case, your brokerage reaches out to another broker that advertises the availability of the stock to buy and sell. Not all brokerages can handle OTC stock transactions, and some charge extra fees to do so, so shop around for one that suits your needs at a price you like.

It can sometimes be hard to buy and sell OTC stocks as quickly as you want, because the market simply isn't as big as for the larger market value stocks on the big exchanges. It's also sometimes hard to find up-to-the-minute information about OTC stock prices, although that's improved in recent years thanks to electronic systems. OTC stock information is generally available through organizations called the OTC Bulletin Board and the OTC Markets Group. The OTC Markets Group is sometimes still referred to as the "Pink Sheets" system, since at one time, it literally distributed daily market quotes on pink sheets of paper.

Small capitalization stocks are also often subject to less regulation by the Securities and Exchange Commission.

OTC and Penny Stocks

Many of the stocks traded over the counter are what are known as penny stocks. That typically means stocks where a single share sells for less than $5.

That can be a bargain for savvy investors, if they manage to catch an up-and-coming company while its shares are still inexpensive. Other investors, including day traders, may buy a penny stock to hold for a short amount of time, hoping for a quick jump in the stock price. Because penny stocks have low prices and low total market value, or capitalization, it doesn't take much trading for their prices to quickly go up and down.

Since penny stocks are relatively risky, investors shouldn't put more money into them than they're willing to lose. They may also wish to set stop-loss orders with their brokers, requesting stock automatically be sold if the price drops below a certain level. You might also want to put in a preset order to sell the stock if it goes above a certain level, to make sure to capitalize on what could be temporary gains. Keep in mind that it can be hard to quickly buy or sell low capitalization stocks.

OTC Stock and Fraud Risks

Low capitalization stocks in relatively unknown companies can be targets for investor fraud. In some cases, company management might lie to investors about company assets or business ventures, planning to effectively disappear with cash from bilked stock buyers.

In other cases, the companies are targeted by outside "pump-and-dump" scammers. These stock manipulators purchase a stake in a penny stock company and then promote the stock to gullible investors, usually without disclosing that they own it. This can be done through telemarketing, through online or print publications touting the stock as a good investment or through posts on digital forums and mailing lists.

Once other investors buy in, driving up the price of the stock, the scammers dump their own holdings. The price goes down, and other investors lose much of their investments.

Make sure to do your own investigation of any stock you buy, and be skeptical of strangers touting investment opportunities online. Look into who owns the company and note their track records, especially if they have a habit of starting companies that fail. The SEC advises you to track down any financial statements and regulatory filings filed by the company and make sure you understand them, including searching for any unusual claims or red flags.

Small Cap Mutual Funds

If you don't want to invest directly in over-the-counter stock, you can invest in various mutual funds that track small capitalization companies. Take a look at any fund's past performance and understand who runs it and what it typically invests in before deciding whether to invest. Also, make sure you understand any fees charged by the fund and how these may affect your ultimate gains.

OTC Stocks and Income Tax

Ordinarily, when you sell stock, you must pay capital gains tax on any gain the stock's value has seen in the time you've owned it. If you've held on to a stock for a year or longer, you pay tax at the long-term capital gains rate that depends on your income bracket; this rate can be 0, 15 or 20 percent. That's often a bargain compared to ordinary income tax rates, which you pay on stock you've held for less than a year and on income from sources like work and bank interest.

If you're buying OTC stock hoping for a quick gain, you may not hold on to it long enough for a long-term capital gain, meaning you'll pay more in taxes on your earnings. Consider the tax ramifications of any investment as you decide whether it's worth it.

If you lose money on stock, you can claim a capital loss. Generally, these first offset taxable capital gains, and you can offset an additional $3,000 in capital losses per year against your ordinary income, rolling over additional losses into subsequent tax years. If a stock you own becomes permanently worthless, you can usually claim its entire purchase price as a loss.