NEW YORK (TheStreet) -- It's hard to check your email without hearing about the next "hot" penny stock that's going to make you rich. But what are penny stocks, and can they really deliver on those promises? Here's my 2 cents worth on penny stocks.
What Are Penny Stocks?
Low-priced, small-cap stocks are known as penny stocks. Contrary to their name, penny stocks rarely cost a penny. The SEC considers a penny stock to be pretty much anything under $5. And while there are sub $5 stocks trading on big exchanges like NYSE and NASDAQ, most investors don't think of these when asked to describe a penny stock.
Most individual investors look at penny stocks like Wall Street's Wild West, an untamed world of investing detached from all the glitz and media coverage that comes with stocks that are traded on major exchanges. While the gains and losses can be pretty impressive in the penny stock world, they're not often heard about elsewhere.
Just because you don't hear about penny stocks every day on CNBC doesn't mean that penny stocks are without drama. Unfortunately, penny stocks have also garnered a reputation as a game filled with scams and corruption. Indeed, penny stocks could be your wildest ride yet as an investor.
So then, if penny stocks usually aren't traded on normal exchanges, where can you buy them?
How to Buy Penny Stocks
Like any other stock you would buy, you can purchase shares of a penny stock through your normal stockbroker -- regardless of whether or not it's listed on a major exchange.
While cheap stocks listed on exchanges like NYSE and NASDAQ aren't typically considered "penny stocks" per se, they can afford a lot of the benefits of penny stocks without quite so much risk. These exchanges have strict listing requirements, and while they might not allow for as much of an upside as "true" penny stocks can, they tend to be more reliable. More often, though, penny stocks trade on listing services like OTCBB and Pink Sheets.
Over-the-Counter Bulletin Board, or OTCBB, is a quotation. Unlike Pink Sheets, which is just a quotation publisher, OTCBB maintains listing requirements (though they're less stringent than those of an exchange). For this reason, OTCBB has a little bit of added legitimacy.
Pink Sheets is a system that provides investors with quotation information on stocks that are registered with it. Unlike OTCBB, however, Pink Sheets isn't registered with the SEC and doesn't enforce any listing requirements. Bottom Line: Pink Sheets stocks are risky.
The Potential Payoff of Penny Stocks
With all the risk involved, why would anyone want to put his or her money in a penny stock anyway? The answer is volatility.
Because penny stocks are prone to violent fluctuation (volatility), many people believe that they'll luck out with a stock that will jump from $0.08 to $8 in two weeks. And it's happened. Scour enough investing message boards and you're sure to find success stories from investors who made a mint while "playing the pennies."
Companies that can successfully make the jump from penny stock to power stock are rare, but when you find them they pay out in spades. Numbers vary quite a bit in the penny stock world, but investors have raked in gains over 1,000% in a couple weeks' time. The real trick is finding the right stock.
The Risks of Investing in Penny Stocks
Even legitimate penny stocks are plagued by very high risk. Two principal reasons that risk is so inherent in penny stock investing are low liquidity and poor reporting standards.
As investors saw most recently with the sub-prime lending market, liquidity problems can be a huge deal for investors. And unlike lending, low liquidity plagues the penny stocks on a daily basis. Because penny stock investing is such a niche area, even relatively low trade volumes can have an impressive effect on a stock's share price. According to the Securities and Exchange Commission (SEC), "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."