How Do Penny Stocks Work?

Penny stocks are common stocks that cost relatively little per share--oftentimes just $1 or $2, and sometimes less (hence the name, since they can often be bought with fractions of whole dollars, or pennies). Penny stocks are often traded through over-the-counter services, and traditionally, stocks listed on exchanges like the NYSE are not thought of as penny stocks, yet the term can be applied to any stock which trades at a low price and with a relatively low volume. Most penny stocks are shares of small companies that usually don't have great market penetration; information on a penny stock company can be hard to find.

Penny stocks work the same way as any other stock: An investor buys up shares and hopes that the company will grow, increasing the value of his equity stake in the company, and then sells his shares and makes a profit. The main difference between penny stocks and larger stocks, such as those listed in the DOW industrial average, is that penny stocks have enormous daily variance, (percentage wise) and carry a huge potential for reward, at the cost of large risk. For big companies, when a stock goes up or down a few dollars in one day, if the stock is trading at $50, it might change only a couple percentage points. This would be considered a large change for one day in a normal stock. In a penny stock that costs less than a dollar, a change in value of one or two cents could amount to the same percentage change. The lower the price of the penny stock the greater this risk vs, reward is magnified. If a stock only cost 10 cents per share, an increase of 1 penny in a day would be 10 percent, a return that many would consider very good for an entire year. The downside is that if the price falls by a penny or two, the stocks decline just as quickly.

The volatility of penny stocks make them an extremely risky investment. Since penny stocks generally trade with lower volumes than large stocks, and they cost much less per share, speculators can drive up the prices of a given penny stock by injecting a large amount of money into them. This provides a means of doctoring the market: the speculators pump money into a penny stock, which raises the price, then the stock then draws attention from the financial industry drawing in funds from average investors, further driving up the price, and as this happens, the speculators pull their money out, making a profit, while the other investors lose money as the price falls back down toward its original level. Penny stocks are often used as a part of email scams, which promise amazing returns, when in reality the mass emails are a way of pumping up prices momentarily for scammers to sell inflated shares and make money. Since information on penny stocks is often difficult to find, they are easier to manipulate. Considering the dangers involved in penny stocks, the average investor is usually better off putting their money elsewhere.

Resources

• Informational about penny stocks