A gray market refers to the unofficial exchange of goods or services outside the usual channels for doing so. In the context of investing, a gray market refers to the trading of securities outside of a regular exchange. In general, a gray market is a legal but atypical or irregular way of conducting transactions, which lies between the white market (legal and customary) and the black market (completely illegal and atypical).
Here are important situations in which the gray market is used for trading securities and investments.
What is the gray market for securities and how is it used?
The gray market is the legal trading of securities through atypical channels, sometimes before official trading is allowed. A gray market can help market participants understand the potential demand for a security before it is officially launched on a standard exchange such as the New York Stock Exchange or Nasdaq.
This trading can take place in the over-the-counter market, using trading symbols that are not the final symbol of the security. For example, three main places where shares can be traded on the gray market are:
- Spinoffs: When one company spins off another, both the parent company and the spin-off may trade on the gray market on a “when issued” basis for several days or weeks. These ‘when issued’ shares have different symbols – usually the company’s regular symbol with a ‘-WI’ appended to it – and they can be exchanged for the company’s shares when trading begins in the ‘normal manner’. When the shares of the parent company and the spin-off are officially distributed to investors, trading in these gray market shares stops.
- Preferred stock IPOs: Preferred shares also trade on the gray market days before officially trading in the regular manner on the standard exchanges. The preferred stock usually has a different symbol than the final symbol during official “regular” trading. Gray market preferred shares often trade a few percent below the official IPO price because underwriters want to distribute them.
- Suspended stocks: Stocks that have violated the listing requirements of a major exchange such as the New York Stock Exchange can be traded on the gray market. They usually trade under a different symbol than when they were listed on the stock exchange.
Don’t confuse gray market securities as merely penny stocks or other potentially fraudulent companies. Many gray market securities transition from one exchange to off-exchange trading, or vice versa, with the gray market being the limbo for trading.
Gray market: pros and cons
The gray market can offer some advantages to investors looking for a potential competitive edge, but it also comes with some disadvantages.
Advantages of the gray market
- First access to effects: The gray market offers investors who know where to look the opportunity to purchase securities before less informed investors.
- Access to securities at a more favorable price: As part of the benefit of seeing securities before their regular debut, investors can find them at a better price. For example, spin-offs traded on the gray market can be more favorably priced than if they were traded the regular way, allowing investors to buy before larger investors drive up the price.
- Less competition: By trading on the gray market, investors can gain access to securities that fewer investors are browsing, especially large investors with more resources.
- Higher yields: Likewise, those who buy preferred shares on the gray market, for example, can secure higher returns than if they buy the regular way.
Disadvantages of the gray market
- Low volume: Gray market stocks typically trade with much lower volume or for a shorter duration than stocks on a major exchange. So you may not be able to buy a substantial position through the gray market or your purchases could move the stock.
- Transactions may not be settled: A gray market purchase can fail if there is a problem, for example if a company pulls out of a spin-off at the last minute.
- Increased risk: Gray market transactions can carry greater risk, such as the potential not to settle, and companies may have even lower disclosure requirements or otherwise lack financial information that is critical for investors to know.
In short
The gray market is the exchange of securities outside of a regular exchange, a practice that can provide benefits to investors who have access to the securities at the time. But the gray market also offers some disadvantages, including low volume and potentially lower disclosure requirements.
