When it comes to equities, movements of share prices on major stock exchanges like the New York Stock Exchange and Nasdaq tend to dominate headlines. But every day, thousands of equity trades are made off of the exchanges in what's known as over-the-counter trading.

Over-the-counter trading is a corner of the investing world that some may find confusing, but the Financial Industry Regulatory Authority is working to improve the public's access to information about that segment of financial markets.

Last year, FINRA began publishing information about trading activity in Alternative Trading Systems (ATS) including so-called dark pools -- private trading platforms, sometimes sponsored by major banks. Most recently, FINRA announced that it will publish information about which firms are trading stocks over the counter but outside of ATSs and the volume of those trades.

But while information published by FINRA may provide a fuller picture of the trading that occurs over the counter in listed stocks, there is another type of over-the-counter trading that involves riskier investments, such as penny stocks, and deserves to be approached with caution by the average investor. To understand the risk involved, it may help to review the basics of trading over the counter.

What is OTC trading?
Over-the-counter trading refers to any trading that takes place off of exchanges, including stock exchanges and commodities exchanges. A host of financial products trade over the counter. In addition to stocks, over-the-counter trading can be done in bonds, currencies and various derivatives. It's a massive part of the global securities market, with over-the-counter trading in certain types of financial products accounting for billions to trillions of dollars in trades every day.

In the case of equities, over-the-counter trading includes both stocks that are listed on exchanges and stocks that are not listed; unlisted stocks are generally called over-the-counter equity securities, or OTC equities, for short. Unlike exchange-listed stocks, which may trade on or off of the exchange -- e.g., on an ATS -- OTC equities only trade over the counter because they are not listed on any exchange.

Why are certain stocks not listed on an exchange?
For its stock to be traded on an exchange, a company has to meet certain requirements. A number of companies are traded over the counter as OTC equities because their small size means they are unable to meet exchange listing requirements such as meeting an exchange's threshold for the number of publicly traded shares or having those shares trade above a minimum price.

Other, larger companies are traded over the counter because they have been delisted from the exchanges for failing to continue to meet listing standards. This often includes companies seeking bankruptcy protection.

But American Depository Receipts (ADRs) -- certificates representing a specified number of shares in a foreign stock -- may also trade as OTC equities instead of on exchanges. That can include ADRs for giant, profitable global companies that have determined that it's not in its best interest to devote the resources necessary to meet U.S. exchange listing requirements and stringent U.S. regulatory requirements.

When a company is listed on a U.S. exchange, the company must follow disclosure rules that require them to file regular reports and financial statements with the Securities and Exchange Commission. The materials filed with the SEC, which are available to the public on the SEC's EDGAR database, are helpful for investors seeking to gain a thorough understanding of a company's performance and financial health.

While the issuers of listed stocks generally must file these reports with the SEC, an OTC equity issuer may or may not, which means there may be limited information about the company available to investors.

Why are U.S. exchange-listed stocks also traded over the counter?
When an institutional investor is making a large trade (think thousands of shares), they sometimes prefer to do so over the counter, perhaps through a dark pool, for the pre-trade anonymity -- and potentially price stability -- such venue can provide.

Institutions and broker dealers don't necessarily want anyone to know what their trading strategies are. When large institutions or brokerage firms attempt to make block trades on an exchange, the market may react in such a way that pushes prices in a direction unfavorable to the institution or firm.

While these trades in listed stocks take place outside of traditional exchanges, the trades themselves are still reported to the consolidated tape after they occur, and the trades must still take place at the best price reasonably available, which is typically at or inside the bounds of the current national best bid and best offer on all trading venues.

What are the platforms for OTC trading?
Listed stocks are often traded over the counter through alternative trading systems. The trades are matched anonymously by an ATS's operators.

For unlisted, OTC equities, brokers often do business through electronic platforms known as interdealer quotation systems, which allow identified brokers to post bids and offers to buy and sell securities.

What investors participate in OTC trading?
Those who trade listed stocks through an ATS tend to be large investors, including institutional investors such as mutual fund operators. Mutual fund companies sometimes make trades through an ATS in an effort to make sure a stock's price doesn't get away from them.

Also, when you place a trade through your online brokerage account, there is a chance that trade is also being routed to an over-the-counter venue, as brokerage firms often may route order to large, wholesale brokerages known as market makers instead of to an exchange.

OTC equities are largely owned by retail investors, according to a 2013 study from Columbia University, who may be attracted to the low price of many OTC equities, including so-called "penny stocks" that trade at under $5 a share. That activity is typically very speculative.

As with listed stocks, investors usually trade OTC equities through their brokers.

What are the risks of trading OTC equities?
OTC equities are not always liquid, meaning it isn't always easy to buy or sell a particular security. The Columbia study noted that there is far less liquidity in trading OTC equities than in exchange trading. In other words, investors seeking to sell their OTC equities may find themselves out of luck because they simply can't find a buyer.

But perhaps the greater risk to OTC equity investors is that there are fewer disclosure requirements for unlisted companies. While a company may appear to be an attractive investment, it may be difficult for investors to judge a company's performance and prospects without seeing information on its earnings, debts, operating expenses and other critical financial information.

While there are examples of small OTC equity companies that go on to see huge success, regulators warn of cases in which OTC equity companies marketed as "the next big thing" turned out to be fraudulent enterprises or scams.

The bottom line: The old adage "know before you invest" can be hard to live up to when investing in non-reporting companies in the unlisted market.

An Alert Investor is a smarter investor.

This article originally appeared on The Alert Investor.
