Stocks, or shares, are a type of security that denote ownership in a corporation. The holder of a stock owns a claim to a percentage of the corporation's earnings and assets. Penny stocks are stocks that normally trade for under $1, often for under a penny.
The most significant difference between penny stocks and other stocks is that penny stocks do not undergo the same level of regulatory oversight. For example, in the United States, penny stock companies do not have to release audited financial records. As a general rule, shareholders have virtually no verifiable information on the inner workings of these companies. This makes it much easier for corporate insiders to act against shareholder interests, and the low per-share price reflects this increased risk of fraud.
Another important difference is how penny stocks are traded. Major exchanges such as the New York Stock Exchange and Nasdaq National Market do not list penny stocks; instead, they are relegated to secondary markets such as the Pink Sheets. Liquidity, a measure of how easy it is to buy and sell a stock, is much lower in secondary markets than in the majors. The lack of liquidity is especially important for traders of penny stocks; because of the low per-share price, it is not unusual for individuals to hold hundreds of thousands, or even millions of shares. When the liquidity disappears, it becomes impossible to exit such large positions without drastically affecting the share price.
Penny stocks have a deserved reputation for fraudulent activity, and over the years a colorful vocabulary has developed to describe the various schemes. One common technique is known as Front Running, or the Pump and Dump. A small group of traders will quietly buy a large block of shares in an inactive penny stock. Once their positions are loaded, they begin spreading extremely positive sounding rumors about the company in an attempt to push up the price. In theory, this will allow them to sell at a large profit. The converse trick, spreading false rumors in an attempt to drive down the price, is known as the Poop and Scoop.
The sub-$1 guideline is not a hard and fast rule. Following the great bear market of 2000, a number of legitimate, fully reporting companies found their shares valued in the pennies. While technically penny stocks, the major exchanges typically gave such companies short term exemptions that allowed them to stay listed as long as they continued to meet reporting guidelines laid down by the SEC.