What Are Penny Stocks, How Do They Work & Are They Worth It?

With their low cost and potentially explosive returns, so-called "penny" stocks often attract investors who want to spend as little as possible in hopes of reaping enormous returns. Typically priced at less than $5, penny stocks can fluctuate significantly over the course of just a few hours; these fluctuations can make large amounts of money for some investors and lose even more for others.

Definition

The term “penny stock” has only a general definition, and even the U.S. Securities and Exchange Commission refuses to offer a precise description. In general, though, penny stocks are stocks, derivatives and other securities that trade at less than $5 per share. Though some definitions hold that penny stocks do not trade on major stock exchanges, the SEC notes that these investments may trade on domestic exchanges, foreign exchanges, private exchanges and electronic quotation systems known as Pink Sheets.

Functions

Penny stocks work much like higher-valued, more traditional stocks. Private companies, typically with very low market capitalization, issue stocks for trading either on public exchanges or in private transactions. Investors purchase shares, often in large quantities, with hopes that the business will increase in value. If the business does increase in value, the stocks become more valuable, and the investor can sell them at a profit. If the business falters or fails to generate a profit, though, the value of the stocks may fall and leave the investor to sell the shares at a loss.

Trading

For penny stocks that trade on public exchanges, buying and selling penny stocks works much like any other stock transaction. Many stocks trade on Pink Sheets or on the Over the Counter, or OTC, exchange, though. To buy or sell penny stocks on the Pink Sheets or OTC exchange, investors must place orders through a broker-dealer firm known as a market maker. The market maker contacts the market maker that represents the stock’s issuer, and the two firms negotiate the transaction. The OTC Bulletin Board, or OTCBB, keeps track of penny stock values.

Value

Because companies that issue penny stocks are typically very small, they usually issue low volumes of stock with values that can fluctuate significantly over very short time periods. Many investors favor penny stocks because even a relatively small increase in value can cause significant increases in stock prices. For investors who do successfully purchase penny stocks at low values and sell them for profits, penny stocks are worth the risk. Many investors, though, lose large amounts of money when the stock issuer declines in value or goes out of business.

Warnings

Many penny stocks are not traded on public stock exchanges and are not regulated by the SEC. For this reason, investors can lose large amounts of money when the unregulated companies simply go out of business or default on their obligations. In addition, scam artists can manipulate the value of penny stocks through a variety of schemes, and many investors lose money after buying shares of seemingly prosperous companies. Penny stocks also tend to trade infrequently, and investors may have trouble selling their shares even if the value increases. Though many investors do make a profit from penny stocks, the stocks are so volatile that the SEC requires investors to receive and read a document describing the various risks of investing in penny stocks.

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About the Author

Keith Evans has been writing professionally since 1994 and now works from his office outside of Orlando. He has written for various print and online publications and wrote the book, "Appearances: The Art of Class." Evans holds a Bachelor of Arts in organizational communication from Rollins College and is pursuing a Master of Business Administration in strategic leadership from Andrew Jackson University.

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