OTC 101 — Part 4 - Advanced Concepts

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 tradeable 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, market makers 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 market makers 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 tradeable) securities.
Spreads are often the result of the amount of information available on a security. This information may come in the form of past trading data, news or company financials. If very little information is available on a security, spreads may be very large because the market maker 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 market makers believe they have sufficient knowledge of the company and the security to buy and sell with confidence.
OTC investors are wise to pay attention to the spread in OTC securities.
Arbitrage
Arbitrage is the trading strategy that takes advantage of the price differential between two or more markets for the same underlying asset. Investors and traders profit from the price differential by buying at the cheaper price and selling at the higher price or vice versa. In liquid markets, arbitrage is a short-term strategy because traders quickly recognize the imbalance and correct their prices.
The large number of American Depositary Receipts (ADRs) and Foreign Ordinaries that trade in the OTC market (e.g., Roche – RHHBY, adidas – ADDYY) make price imbalance a concern for OTC traders and investors. ADRs represent a set ratio of home market shares; thus, movement in the home market price and foreign exchange considerations will directly affect the price of the ADR. Foreign Ordinaries should theoretically mirror home market trading once currency rates are considered.
ADR and Foreign Ordinary investors should be aware of the home market symbol, venue, and trading patterns, as well as current foreign exchange considerations.
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 sellers 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.
Some brokerage houses do not allow the shorting of OTC securities due to the lack of liquidity or low market prices in many issues. If short selling is allowed, investors must be very careful when employing this strategy.

http://www.otcmarkets.com/learn/advanced-concepts