In U.S. financial markets, penny stocks commonly refer to any stock trading outside one of the major exchanges (NYSE, Nasdaq, or AMEX), and is often considered very risky.

In the UK, penny shares as they are more commonly called, usually refer to a stock and shares in small cap companies, which is defined as being companies with a market capitalization of less than £100 million and/or a share price of less than £1 with a bid/offer spread greater than 10 percent. In the UK Penny Shares are covered by a standard regulatory risk warning issued by the Financial Services Authority(FSA).

Trading penny stocks is the easiest way to make the large profits with the least amount of startup capital. Why? Because of their volatility. It’s a lot more difficult to find a $50 stock that goes up 100 percent in a short time, but there are hundreds of penny stocks that go from a penny to two cents, a dime to 20 cents, or a dollar to two dollars in a matter of days.

There are risks associated with trading penny stocks. In many cases these risks can be mitigated or avoided altogether, but there is always the chance of losing money.

Penny stocks have a bad name, because scammers use thinly traded shares to take advantage of people, with pump and dump schemes, and by providing manipulative information. Penny stocks also get a bad name because many investors lose money trading them, when they don’t understand what their investing in, or how to trade these penny stocks. Many people trade penny stocks before they learn about the easily avoidable dangers, and then complain that penny stocks are dangerous. However, for those investors who do learn how to find good quality companies, and take the time to understand the dangers and how to avoid them, there are tremendous profits to be made.

During a ten year period between 1993 and 2003, the growth in the volume of shares traded on the OTCBB — almost entirely comprised of penny stocks — eclipsed trading volume on the Nasdaq and NYSE (See Figure 1).

Figure 1: Volumes for the Nasdaq and OTCBB. OTCBB volume grew 8900 percent between 1993 and 2003, eclipsing both the Nasdaq (638 percent) and NYSE (512 percent) volume increases by a wide margin.

Volumes on the Pink Sheets  have grown even faster. In 1998, about 9 billion shares traded, and by 2003, volumes had surged to 187.5 billion–an incredible increase of more than 2000% in just five years. (See Figure 2).

Figure 2: Rise in trading volumes on the Pink Sheets

How do you trade penny stocks? Are there any techniques that work best?

Technical analysis that uses indicators and statistics to predict price movements is one possible approach, according to Investopedia. But due to the rampant growth of the penny stock phenomenon, technicians haven’t had the time to build a strategy–assuming anyone is interested in coming up with one. As far as analyzing sub-penny stocks, it would require a new system for charting and monitoring to determine the significance of a 0.0001-cent move, and there is no telling whether or not it would work.