How Do Penny Stocks Work?

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The term "penny stock" typically refers to a share of stock that trades at less than $5 per share. Penny stocks are typically issued by small companies that are seeking capital but do not qualify to sell shares on larger stock exchanges, such as the New York Stock Exchange or the Nasdaq. While penny stocks offer some opportunities for investors who can't afford "blue chip" stocks, they also present some risks that are not frequently found in more established investments.

Issuing Penny Stocks

The process of issuing penny stocks closely resembles the process for issuing stocks to larger exchanges, only on a smaller scale. Companies that issue penny stocks typically have low market capitalization and are often startups in search of seed capital. The company issues shares of ownership for purchase by the public. These shares are available through over-the-counter markets or through computerized quotation systems known as "pink sheets."

Trading Penny Stocks

A standard penny stock trade is arranged by a broker-dealer, or agent. The agent arranges a trade based on the amount someone is willing to pay for a stock, also called the "bid price," and the amount at which someone is willing to sell a stock, also called the "ask price." The difference between the bid price and ask price is known as the "spread." The spread measures how much money the trade made or lost.

Advantages of Penny Stocks

A major advantage of penny stock investing is that investors do not require a large bankroll to participate. Penny stock investors can often buy hundreds or thousands of shares for $1,000 or less. The small share price of penny stocks also means the stock does not need to have a large increase in its share price to reap a major profit. For instance, an investor purchases 1,000 shares of XYZ Software Inc. for $1 per share, for a total investment of $1,000. If the share price increases by $0.10 to $1.10 per share, the shareholder's investment grows from $1,000 to $1,100.

Risks of Penny Stocks

The volatile nature of penny stocks allows for rapid increases in profits, but it can also lead to sudden losses. Since numerous penny stocks are issued by startup companies, penny stock investors risk losing much or all of their investment if the startup fails. Penny stocks are also susceptible to "pump-and-dump" schemes, in which traders artificially inflate a stock price, then sell their shares in massive quantities, leaving investors with worthless shares after the sales. Jordan Belfort, played by Leonardo DiCaprio in the 2013 film "The Wolf of Wall Street," was the architect of a major pump-and-dump scheme involving penny stocks.

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