What Is a Penny Stock?

   A penny stock is generally defined as a very low-priced stock from a very small company.  Most in the investment community think of penny stocks as stocks not traded on large and well-regulated markets such as NYSE (New York Stock Exchange) and NASDAQ (National Association of Securities Dealers Automated Quotation Systems).  The SEC (U.S. Securities and Exchange Commission), however, allows for a definition that includes some stocks traded on those larger exchanges.

Where Can Penny Stocks Be Found?

     Most penny stocks are bought over the counter, and are thus listed on the OTCBB (Over the Counter Bulletin Board).  Penny stocks offered are also listed on Pink Sheets, so named because the listings used to be printed on pink paper.  Now, however, Pink Sheets is an internet publication, produced by a private company that is not bound by SEC regulations. 

The Profit Potential of Penny Stocks

     Penny stocks are attractive to investors because of their low price—always under five dollars, and frequently under one dollar. Partially because of this low price, they are capable of great investment growth in very short periods of time. It is far easier for a stock that costs $1.00 a share to double in worth than it is for a stock priced at $500.00 a share.

Risks Associated With Penny Stocks

     The risks associated with penny stocks fall into four basic categories: liquidity, volatility, lack of financial reporting, and potential scams. The first is their limited liquidity. Liquidity risk refers to a stock's ability to be rapidly traded. Since penny stocks are from small companies, there are fewer shares to be traded and fewer shareholders to release shares into the market for purchase. There also tend to be fewer willing buyers when a shareholder wants to unload a particular penny stock.

Volatility of Penny Stocks

     Related to their limited liquidity is the volatility of penny stocks. A penny stock's limited liquidity increases its volatility—its tendency to gain or lose value rapidly. The same volatility that gives penny stocks the potential to double, triple, or quadruple in value overnight means that they can decrease in price just as quickly. Investors in penny stocks can easily lose their entire investment. Some penny stocks lose almost all of their value over the long term.

Lack of Reliable Financial Reporting on Penny Stocks

     Another drawback of penny stocks is the lack of reliable financial reporting available for any specific stock. The organizations that list and trade penny stocks require very little information from the companies that issue the stocks. By contrast, the NYSE and NASDAQ require minimum accounting standards for the companies whose stock they trade. They also require the reporting of any changes that affect a company's financial health.

Penny Stock Scams

     The fourth major disadvantage of penny stocks is that their limited liquidity and extreme volatility make them suitable vehicles for unethical stock traders. One of the best-known questionable practices centering on penny stocks is called the pump and dump. The pump and dump can be set in action either by heads of the company offering the penny stock, or investors who've chosen a specific penny stock for this purpose. 

How Pump and Dumps Work

     An investor or group buys as many shares as possible of a penny stock while its price is extremely low. Then the scammer(s) make many false posts to penny stock Web sites and blogs, predicting huge profits for that small company. The inflated talk (pump) attracts more investors, and the price of shares rises rapidly due to sharp increase in demand. When the scammers feel the penny stock price has risen as far as it will go, they sell (dump) all of their shares. Once they are safely rid of the penny stock, they stop making their positive false postings.  The “buzz” about the penny stock ceases, and the price plummets, leaving innocent investors to take the loss. The pump and dump, and other penny stock frauds, remain common, despite their criminality.

Penny Stock Strategy

     A legitimate investor can make a profit from a given penny stock.  This depends, however, on whether he or she can determine correctly when to sell the penny stock shares.  Penny stocks should definitely be short-term investments.  Most investors, however, concur with the SEC that penny stocks are a very high risk investment.

Additional Resources

• SEC Penny Stock Rules

www.sec.gov/answers/penny.htm

• Spam Stock Tracker
• Knobias provides many useful financial tools for stock investing