Penny stocks are specifically defined by the SEC as stocks with a share price less than $5. People in the financial industry will often use terms like penny stocks, small caps and nano caps interchangeably, and any small company that trades outside of securitized exchanges on an over-the-counter (OTC) listing service like the OTCBB or Pink Sheets is often considered to be a penny stock. But, according to the strict SEC definition, even a well-known large cap company like Sun Microsystems (SUNW) can sometimes be classified as a penny stock.
Nevertheless, even though market capitalization doesn't factor into the precise definition, the fact is that the vast majority of penny stocks represent companies that have a very small market capitalization. That means that penny stocks have the same advantages and risks as micro caps and small caps, namely, the potential for extremely high capital gains along with the danger of extreme losses.
The SEC warns, "Penny stocks may trade infrequently, which means that it may be difficult to sell penny stock shares once you own them. Because it may be difficult to find quotations for certain penny stocks, they may be impossible to accurately price. Investors in penny stocks should be prepared for the possibility that they may lose their whole investment."
Fraud is another major risk in trading penny stocks. It's easy to manipulate a stock when there's little or no information available about the company.
There are many scam artists who try to profit by using infamous "pump and dump" methods. For example, these fraudsters purchase large hunks of a penny stock's shares, then spread hype about them through mass spam emails and junk faxes, which make outrageous claims about these unknown company's profit potential and urge you to "Buy now!!!" No matter how ludicrous the messages may be, some people respond to these spam emails and purchase the penny stock being hyped, which quickly drives the price up. The fraudsters immediately sell their shares, and the price sinks down even lower than it was in the beginning. People who respond to pump and dump scams typically lose about 8% of their investment in only a couple of days, while spammers who buy low-priced stock before sending out emails usually see a return of about 5 to 6%.
Do not respond to anonymous emails that advertise a cheap stock you've never heard of. If you're going to respond at all, at least trade in the direction of the fraudsters and sell short ˜ but if you do this, know that the profits you make are coming out of the pockets of innocent people who have been tricked. You are profitting on someone else's unethical behavior.