What Are Penny Stocks?

Probably anyone who has even a cursory interest in investing has dreamed of finding that one stock that will turn out to be the next Intel or Google. This hope of becoming one of the lucky few who make a fortune on the stock market is the root of people's fascination with the low-priced securities called penny stocks. What exactly are penny stocks? What are their main characteristics and what are the pros and cons of investing in them?

Identification

There are different definitions of the term penny stock. Some people apply the name penny stock only to stocks priced at less than $1 per share. The Securities and Exchange Commission (SEC) defines a penny stock as one that is issued by a very small firm and priced at less than $5 per share, typically with limited trading volume (low liquidity). In the United Kingdom, a penny stock is one that costs under one pound per share and has a total market capitalization under 100 million pounds.

Function

Penny stocks are speculative, high-risk investments. They are attractive to investors because of the possibility of very high returns. There is some validity to this. Even giants like Microsoft started as small companies. Many penny stocks are new firms and some will do well. However, the failure rate is high and many penny stocks eventually become worthless when the company goes out of business. Because penny stocks attract speculators, sudden surges in volume can often result in large price changes, giving these stocks a tendency to be volatile.

Features

Most penny stocks are traded over the counter through quote services (often called "pink sheets") rather than on major exchanges like the New York Stock Exchange or NASDAQ. As such, these stocks are not required to file with the SEC and are not subject to many of the disclosure regulations. Over-the-counter listing services do not impose the standards that major exchanges do on listed stocks.

Considerations

If you want to speculate by buying penny stocks, be aware that thorough research is even more important for a high-risk investment than for more conventional stock purchases. There are some common problems you need to watch out for when buying penny stocks. First, penny stocks can be difficult to sell due to low liquidity. Wide price swings are common, especially when a stock draws the attention of speculators. Information about the stock may be difficult to obtain, especially for new companies that don't yet have a long trading history for you to evaluate. Finally, stocks listed on the pink sheets, in addition to not falling under some SEC regulations, aren't subject to the standards imposed by major stock exchanges.

Warning

Because of the limited regulation of penny stocks and their high volatility and low liquidity, they are vulnerable to misrepresentation. "Business Week" magazine has estimated that up to half of all penny stock trades may be the result of scam artists. Be aware of the possibility of overstated reports about a company's prospects, and avoid relying on Internet websites that promote penny stocks. It's possible to keep from being defrauded by dealing only through recognized brokerages and information sources that can be independently verified.

Resources

• The Lowdown on Penny Stocks