Over-The-Counter Trading Strategy – What Is It? (Backtest, Performance, and Analysis)

Not all securities trade on standard and regulated exchanges. In fact, not even all stocks trade on a standard exchange. Some trade on over-the-counter marketplaces. Wondering what an over-the-counter marketplace is, and how over-the-counter trading works? Can you make an over the counter trading strategy?

Over-the-counter (OTC) trading refers to trading that is done directly between two parties, without the supervision of an exchange. This type of trading is carried out via electronic marketplaces handled by a network of market makers and dealers. The electronic marketplaces where this kind of trading takes place are known as over-the-counter markets.

In this post, we take a look at over-the-counter trading. At the end of the article, we make a backtest of the strategy.

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What is the over-the-counter (OTC) market?

An over-the-counter market is an electronic marketplace where trading is done directly between two parties, without the supervision of an exchange.

It is a decentralized market in which market participants trade stocks, commodities, currencies, or other instruments directly between two parties and without a central exchange or broker. In contrast to exchange markets that have physical locations, OTC markets do not have physical locations, and trading is conducted electronically.

A wide range of financial securities are traded on OTC markets, and they include financial instruments such as stocks, debt securities, and derivatives, as well as commodities.

In general, stocks that are traded on the OTC market are typically those of small companies that cannot meet the requirements to be listed on formal exchanges. However, some big stocks, especially foreign stocks via American Depository Receipts (ADRs) trade on the OTC markets as well.

Unlike exchange markets that use an auction market system, in an OTC market, dealers act as market-makers by quoting prices at which they will buy and sell a security, and a trade can be executed between two participants without others being aware of the price at which the transaction was completed. The stock exchange, for example, has the benefit of facilitating liquidity, providing transparency, and maintaining the current market price.

In an OTC trade, the price is not necessarily publicly disclosed. In fact, OTC markets are generally less transparent than exchanges and are also subject to fewer regulations. As a result of the way they are structured, liquidity in the OTC markets may come at a premium. Although OTC markets are regulated by the Financial Industry Regulation Authority (FINRA), the regulation is not as stringent as that of main exchanges, which makes the market more flexible but also with some serious risks.

One of the most significant is counterparty risk, which is the possibility of the other party’s defaulting before the fulfillment or expiration of a contract.

Also, with its lack of transparency and weaker liquidity relative to the formal exchanges, the OTC market is home to market manipulations and some shady deals. The situation is even worse for derivative contracts, given their flexible designs.

The more complicated design of the securities makes it harder to determine their fair value, so it comes with the risk of excessive speculation and unexpected events that can hurt the stability of the markets. This was what happened in 2007/2008 when a sudden lack of liquidity in mortgage-backed securities and other derivatives such as CDOs and CMOs, which were traded solely in the OTC markets, led to a global financial crisis. As a result, FINRA introduced the use of clearinghouses for post-trade processing of OTC trades.

How does over-the-counter trading work?

The OTC market works as a channel through which two counterparties can execute their trade outside of formal exchanges and without the supervision of an exchange regulator. The market is decentralized and has no physical location. All trades take place electronically and directly between the two transacting parties.

In the US, the over-the-counter market is run through networks of market makers. The main networks are managed by the OTC Markets Group and regulated by the Financial Industry Regulation Authority (FINRA). These networks provide quotation services to participating market dealers, and the trades can be executed by dealers online or even via telephone.

Unlike trading on formal exchanges, over-the-counter trades are not standardized — clearly defined range of quantity and quality of products, and prices are not always published to the public. OTC contracts are bilateral, and each party could face credit risk concerns regarding its counterparty.

The OTC market allows companies that are not listed on the major exchanges to raise money from the public by selling their stocks and other securities to them over the counter. It is the default market for some securities, like corporate bonds, and also a viable alternative for companies that don’t meet or maintain the requirements to list their shares on the major exchanges (a certain number of shareholders or monthly trading volumes).

Some companies that don’t want to pay the listing fees or be subject to an exchange’s reporting requirements may opt to remain on the OTC market by choice. In today’s world of online trading, the average investor may not know the difference between buying stocks on the OTC market and buying on the main exchange. After all, OTC stocks are assigned a unique ticker symbol and are usually available for trading via major online brokers.

Differences between the OTC Markets and Stock Exchanges

The main difference is in the decentralized nature of the OTC market. But apart from that, there are other differences. One of them is the amount of information that companies make available to investors. Exchange-listed companies are mandated to regularly provide the investing public with information about their operations via quarterly and yearly reports, company news and filings, and real-time trading data.

On the other hand, OTC-listed companies are not obligated to comply with that rule. As such, there is much less available information on OTC stocks. With less transparency and regulation, the OTC markets can be riskier for investors, and sometimes subject to fraud. For example, penny stocks are traded in the over-the-counter market and are notorious for being highly risky and subject to scams and big losses. As a result of the lack of liquidity in OTC stocks, the market is rife with pump-and-dump schemes.

Nonetheless, the OTC market is also home to many American Depository Receipts (ADRs), which allow investors to buy shares of foreign companies. The fact that ADRs are traded on the OTC market doesn’t make the companies riskier for investment purposes. For example, Nestle, the Swiss giant, is traded on the OTC market (the ticker code is NSRGY).

What is the size of the OTC market?

In the US, there are more than 12,000 securities traded on the OTC market. OTC securities come from a wide range of financi