Penny stocks, also commonly referred to as small-cap stocks, are loosely defined as a stock with a share price below $5. The US Securities and Exchange Commission (SEC) defines them as such, however, penny stocks are often defined as a stock with a share price below $1 by those in the investor community.

Penny stocks are the stock market's equivalent of junk bonds in the bond market. Investing in penny stocks can be much riskier than trading mid to large-cap stocks. Severe and long lasting drops can quickly occur, with little warning. Conversely, penny stocks can yield rapid gains, sometimes up to +1000% in the matter of days. This, coupled with the low price, often lures new investors into trading penny stocks.

The difference between penny stocks and blue-chip and mid- cap stocks is important to understand before you invest. Whereas the market performance or normal mid to large-cap stocks is driven primarily by fundamentals, penny stock performance can be much more pliant to investor speculation. A company's market capitalization (cap) derives from its stock price multiplied by the shares outstanding. This number is therefore the sum dollar value of all of the company's shares at that time. So a penny stock has less shareholders than a mid-cap stock and trades on a far smaller volume per day. This is why penny stocks are so speculative. Any sudden change in demand or supply for the stock will be felt quickly throughout the entire framework. As earlier stated, this can be good (less people to share the profit with), or bad (less people to shoulder the loss). Penny stocks are much more volatile than mid or large cap stocks and this is why many investors regard them as a gamble.

One of the justifications for investing in penny stocks is the notion that many of today's blue-chip stocks, such as Google and Microsoft, were once penny stocks. This is a misconception, though, because after you adjust for stock splits, it becomes apparent that these company's shares were actually almost never trading on par with penny stocks. Investors often overlook this fact and look for the next Microsoft when buying penny stocks.

Because of the lower trading volume, penny stocks lack "liquidity," which means that investors can find it more challenging to buy or sell. Just like with junk bonds, lack of liquidity opens the gate to stock manipulation by fraudulent investors.

Many novice investors are eager to jump into the penny stock trade because of the potential for enormous gains. Just as with gambling, though, an investor must be ready to lose everything that they have invested when dealing with penny stocks. Furthermore, historically speaking, huge rises in penny stock value are incredibly rare. Even in the few instances where this has happened, the price is usually unstable, and falls as quickly as it rose. If you are new to investing, be sure to research the company in which you are investing. Analyze their fundamentals and be aware of the potential risks involved in the penny stock trade.

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