This term is generally used to refer to stocks with a price below $5. The name also comes from the fact that most penny stocks have either started or will end at $0.01 (a penny).
Penny stocks are extremely cheap stocks; so cheap that they usually do not follow the normal market capitalization rules of being listed on major exchanges, so are always traded OTCBB or through Pink Sheets. This is the main distinction between “Penny Stocks” and “Low Price Stocks”, like CitiGroup (C) or Sprint (S), which do sometimes trade under $5, but are listed on major exchanges because of the adherence to specific rules.
There are many reasons why a company could be traded as a penny stock. By far the most common are companies that issue an IPO to raise money, but the company ends up not growing or going completely bankrupt, with its outstanding shares still being circulated by investors in the hope it one day rises from the ashes.
Other examples include very large companies that come to the very edge of going out of business. Pier 1 imports falls into this category; during the height of the financial crisis it was looking at about $0.11 stock prices, but its stock has since recovered.
Occassionally penny stocks do “break out” and make it big: Monster Energy Drinks has been circulating under different names since 1936, and was trading below $1 as late as 1995 before its energy drinks caught on and business took off. However, most cases stay in the first category of stocks that never really go anywhere.
Difference between Penny Stocks and “Low Cost” Stocks
The major difference between the two types of stock is what drives price changes. For “Low-Cost” stocks, the behavior is the same as any other stock listed on a major exchange; the price may be more volatile, but it goes up with strong earnings and profits, and falls with bad news.
Penny stocks, on the other hand, often have prices shift through pure speculation; a flood of penny stock investors will sweep in to one stock over a short period, driving the price up, then start fleeing almost as fast, crashing the price back down. Penny stocks are very frequently the target of market manipulation; a small group of investors or “promoters” buy in to a stock, then try to attract as much attention as possible, and sell of their shares at the height of the hype. The investors who fell for the “hot tips” suddenly can find no new buyers for the shares they hold, making them worthless.
Companies who are represented by penny stocks can sometimes manipulate the prices themselves; it is not uncommon to see 10,000 for 1 reverse stock spits among penny stocks where the company wants investors to see a sudden jump in price to attract attention.
A main characteristic of penny stocks is a very high bid/ask spread (the difference between the minimum price someone is willing to pay for a stock, versus the minimum price a buyer would be willing to sell for), and extremely low volume; there can be days or weeks where a penny stock does not trade at all.
If you are considering investing in penny stocks, just remember that more fortunes have been made short selling penny stocks than buying them.