Since the 19th century, penny stocks have been part of the American investment world. This is where the stocks got their names, since modern penny stocks almost never cost a penny. They’re usually more like ten cents to five dollars. Now, let’s look at the risks of working with penny stocks, then the opportunities they can provide.

Penny stocks are share offerings made by companies that are either too new or too small to be listed in the major exchanges. These have a potential to grow a lot for a relatively small initial investment, but they can also be part of unpleasant pump and dump schemes. Like anything else in the over the counter (OTC) market, the buyer should beware.

Choosing penny stocks reasonably means that you need to have an independent appraisal of the company’s business model. Much like buying shares of any other kind of publicly traded company, it’s necessary to understand everything about the company. That means knowing what they do, what they make, what products are offered, how their business model works and who their major competitors are.

One of the most appealing things about penny stocks is that the majority of businesses offering them are quite simply put together. One typical type is that of a mining company, which will only be profitable when the price of the material it mines reaches a certain level. There are also some oil exploration stocks which use this kind of valuation.

Penny stocks are rated as a high risk vehicle by the Securities and Exchange commission. Some of the risks you’ll encounter when dealing with these stocks include incomplete and indirect financial reporting, limited liquidity and even complete fraud. People who are playing with a day trading strategy will find that sudden demands for penny stock creates enormous volatility. Penny stocks are hard to short sell for this reason.

The financial reporting guidelines on penny stocks are actually pretty loose. Unlike the national exchanges, not much is required of companies that list this way – in fact, sometimes these stocks will just de list for a few days! In the investment type called Pink Sheets, penny stocks have nearly no regulatory requirements at all, including few to no minimum accounting standards or reporting guidelines.

Because these stocks aren’t standardized and don’t have an generally accepted requirements for accounting, they can be extremely vulnerable to being manipulated or even just plain fraud. People posing as independent observers can encourage people to run up the price, then they sell and de list the stock. This is the classic pump and dump scam.

Now, that doesn’t mean you should be scared off of these stocks entirely. There are lots of real, legitimate start up companies, and they have to get going somewhere. Anyone who can pick a winner will get a handsome reward.

If you have the ability to spot companies that have promise, your payout will be huge. Even if you lose on most of your stock picks, the single winner will be such a big gain that you’ll forget about the ones that didn’t work.