How Pink Sheet Trading Works
How Pink Sheet Trading Works
With over 10,000 companies and billions of dollars in value being traded on the OTC markets, such as the Pink Sheets, it is remarkable how seldomly these markets are discussed. This article aims to explain what pink sheets are, the advantages and disadvantages they present to investors and companies, and some best practices when investing in equities on the Pink Sheets.
What is Pink Sheet Trading?
Pink sheets (also known as “pink slips”) are listings for stocks that trade over-the-counter (OTC) rather than on a major U.S. stock exchange such as the New York Stock Exchange (NYSE) or NASDAQ. Pink Sheets is also a private company that helps broker-dealers market the shares of over-the-counter (OTC) equities they represent. Many pink sheet listings are for companies that cannot meet the listing requirements for major U.S. stock exchanges. Some companies choose to sell their shares through the OTC network to avoid the greater costs and regulatory requirements for listing on an exchange, while still reaping some of the liquidity benefits that come with going public. Most pink sheets are cheap penny stocks, meaning they trade at less than $5 per share. Trading in pink sheets is seen as highly speculative. Due to the lack of financial information required to list, pink sheets are prone to fraud and price manipulation. A shell company without an active business or assets can list on OTC networks. Often, the shares trade infrequently and in low volumes, making it hard to buy or sell when the investor wants.
Pros and Cons of the Pink Sheets
Pros:
Companies on the Pink Sheets are not charged high listing fees, such as the $500,000 and $75,000 fees required by the NYSE and NASDAQ respectively.
High disclosure requirements are often incredibly costly for companies looking to go public. Companies listing on the Pink Sheets save on these costs due to the lower disclosure requirements imposed by the platform.
The Pink Sheets provides small companies access to capital.
The typically low share price of companies trading on the Pink Sheets platform makes it easy for investors to afford shares, and can yield returns of high multiples if the company succeeds.
Cons:
Fewer disclosure requirements can lead to outdated, inadequate, or incorrect information given to the investor.
Shares trading on the Pink Sheets carry significant liquidity risk and are typically far more volatile than stocks trading on major exchanges.
It is difficult to value companies listed on the Pink Sheets due to the lack of information provided to investors.
Pink sheet listings are prone to fraud and price manipulation.
OTCBB vs. Pink Sheets
Pink sheet listings are OTC, but should not be confused with over-the-counter bulletin board (OTCBB) securities.
OTCBB is an electronic system that displays OTC securities with real-time quotes and volume information. Shares listed on the OTCBB carry an "OB" suffix and are required to file financial statements with the SEC. When compared to major exchanges, OTCBB has fewer barriers to entry for companies since OTCBB only requires that financial statements be filed with the SEC and other relevant regulators. Like Pink Sheets, OTCBB gives brokers and dealers a mechanism to list their bidding and asking prices to complete transactions. Both Pink Sheets and OTCBB also typically contain companies too small to be listed on major exchanges. Some companies on OTC platforms may have been kicked off of major exchanges for failing to meet the exchange requirements (such as the share price falling below a set level). Overall, the OTCBB platform is considered less risky for investors than the Pink Sheets platform, because the OTCBB requires that financial statements are filed and its companies generally carry less liquidity risk.
Shares trading on the Pink Sheets platform have a "PK" suffix and are under no requirements from the file financial information to the SEC. While companies listing on the Pink Sheets platform do have to file a Form 211 (which includes some financial information) with the OTC Compliance Unit, these companies are not obligated to make their finances transparent to investors or the broker-dealers who market the securities. As such, investors may not have adequate information to make an informed investment decision about many companies listed on the Pink Sheets. In addition, most pink sheets are considered penny stocks and may operate on a local level rather than on a national level. Pink sheets generally carry a considerable amount of liquidity risk, resulting in wide bid-ask spreads (with bid being the highest buy-side price quote and the ask being the lowest sell-side price quote), difficulty in finding an accurate price, and difficulty in selling a position at the desired time.
Brief History of the Pink Sheets
The Pink Sheets began in 1904 when the National Quotation Bureau (NQB) printed an inter-dealer quotation service on pink paper. During the 1970’s, through the 1990’s, the NQB owner had no interest in developing sophisticated methods of electronic quotation. Due to the owner’s unwillingness to adopt new technologies that were becoming commonplace for modern exchanges, the Pink Sheets remained a paper quotation service that mainly attracted small, financially troubled, usually illiquid companies. As a result, the Pink Sheets failed to participate in the great economic surge of midcap and smaller listed stocks during this period.
In 1997, a new owner purchased the NQB and changed its name officially to Pink Sheets. This new owner immediately developed new electronic products and information services which helped facilitate trading and improved the transparency of the companies on the platform.
As the Pink Sheets are widely considered a “Wild West” with a wide variety of companies listing on the platform, the Pink Sheets has recently developed market “tiers” to best inform investors on the risk profile of the stocks they consider investing in on the platform.
The OTC Market Tiers
OTCQX: Many companies in this tier are large companies that are comparable to those listed on the NYSE and NASDAQ. Each issuer in the OTCQX must appoint a Designated Advisor for Disclosure (DAD) who is required to participate in the preparation of the company’s disclosure statements and prevent issuers with inadequate or questionable disclosure from joining OTCQX. The OTCQX has become popular with foreign companies wanting to list in the U.S. who are more comfortable with the OTCQX requirements, which are more similar to European systems than to the requirements of the NYSE and NASDAQ. Companies listing in this tier must have a share price over $1.
OTCQB: Companies in this tier report to the SEC and are comparable to companies discoverable on the OTCBB. While there are no qualitative standards to be in this tier, listed companies’ financials must be audited in order to report to the SEC.
Pink Sheets Current Disclosure: The U.S. companies in this tier do not report to the SEC, but they do report to the Pink Sheets. Their financials do not have to be audited or comply with Sarbanes-Oxley rules, which are U.S. laws that mandate certain financial disclosures from publicly traded corporations traded in the United States. A foreign company qualifies for this tier if they report to their own country’s version of the SEC. Therefore, some of the foreign companies trading in this tier are higher quality investments and are not microcaps. However, these companies may be far less liquid trading in this tier than trading on an exchange in their home country.
Pink Sheets Limited Disclosure: Some companies in this tier have financial reporting problems, significant economic distress, or are in bankruptcy. However, companies in this tier still provide some information, though it may be limited. Some companies in this tier may simply be unwilling to meet the disclosure standards in the Pink Sheets Current Disclosure tier.
Pink Sheets No Information: Companies in this tier are either unwilling or unable to provide disclosure, whether to a regulator, an exchange, or the general public.
Pink Sheets Caveat Emptor: Companies in this tier have inadequate public disclosure and are actively being “pumped and dumped.”
Pink Sheets Trading Best Practices
Be aware of what tier the prospective investment falls in on the Pink Sheets tier system. This will give the investor an idea of the risk profile of the prospective investment. The tier system also allows investors to invest based on how little financial disclosure they are comfortable with.
Some companies in the pink tiers offer limited information on the Pink Sheets website, despite their option not to. Investors should take advantage of any disclosure they have access to before making an investment.
If the prospective investment is a foreign company, it is worthwhile to research the securities regulations of the company’s home country. This will give more insights into the risk profile of the country, as for example, a company listed in Frankfurt or London will have equally as stringent laws as a major exchange in the U.S., but a Shanghai-listed company would be operating under very different rules.
Beware of “pumping and dumping.” When a penny stock’s value rises sharply, it may be because the company has experienced some recent victories that justify the price increase or it may be due to price manipulation, which is more common in pink sheets than in major exchanges. Keeping up with company news is a great way to not end up a victim of price manipulation.
Treat the position as a long-term investment. The best pink sheet investments are companies with real long-term growth prospects, not pump and dump schemes. Because most companies trading in the Pink Sheets are valued at less than $5 per share (with some at less than one cent), the appreciation of these shares has the potential to yield returns worth multiples of the principal investment. With adequate research, an investor can find a pink sheet investment opportunity worth holding in the long-term.
Don’t enter the position without a plan. Trading in any market without a plan means opening the door for one’s emotions to take control of decision making. Emotions are the Achille’s heel of trading, as most people do not know how to control their emotions when making and losing money (especially losing money). This is why it is best to make a plan ahead of time, before the emotional reactions kick in. Limit orders and stop-loss orders are a great way to manage risk, though the volatility and lack of liquidity typical of pink sheet markets can make these techniques challenging.
Keep a finger on the pulse of the broader markets. Broad economic trends still have a profound effect on equities trading on the Pink Sheets. Today, in anticipation of interest rate hikes, institutional investors are selling off positions in riskier investments and asset classes. Equities trading on the Pink Sheets may be first on the chopping block in this sell-off considering the speculative nature of these investments, so as a pink sheet investor this is something to watch in the near-term.
While the excitement of making a high return on investment on pink sheets can be realized in some cases, overall equities on the Pink Sheets make highly speculative investments capable of losing the investor most or all of their money. Many CEOs of companies listed on the Pink Sheets agree that these markets are underregulated and aspire to clear the cost hurdles necessary to list on one of the major exchanges. While Pink Sheets has an important role to play in financing small companies that may be experiencing tough financial circumstances, investors should always be wary of the fraud and price manipulation that has persisted in these markets for decades.