The term “penny stock” generally refers to stocks that trade below five dollars per share, or that were issued by small companies with limited revenue. The trading market for penny stocks is thin, and is usually dominated by one or two brokerage firms who have an interest in the companies’ stock.
Penny stocks are considered speculative, and the SEC requires that brokerage firms document a customer’s “suitability”, and obtain a signed written agreement prior to engaging in penny stock transactions. Broker dealers are also required to provide customers with a risk disclosure document concerning the risk of the penny stock market.
Penny stocks are frequent the targets of “pump and dump” schemes where a brokerage firm with a large position, or a favored client, aggressively tout the stock, which causes a dramatic rise in price, during which the brokerage firm or its preferred client, sell their shares into the market. When the selling is concluded, and the firm moves on to their next target stock, there is little to support the price of the penny stock, and it gradually (sometimes violently) drops in price.