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Penny stocks have been around for a long time - they've been part of American investment strategies since the 19th century. That's where these stocks were named, since the modern penny stock actually costs somewhere between a dime and five dollars, not a penny. Let's have a look at the risks you incur by investing in these stocks, as well as the ways they can help investors profit.

Penny stocks are share offerings made to investors by companies that are just too small or new to have a listing with the major stock exchanges. They have significant growth potential, and the initial investment can be quite small, but you run the risk of encountering a pump and dump scheme. Like anything else dealing in the OTC (over the counter) 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 involved include incomplete or indirect reporting of finances, fraud, and limited liquidity. People playing using a day trading strategy, sudden demand on penny stocks can create wide ranging volatility, which also makes it hard to short sell them.

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 there are no generally accepted standards or standardization for penny stocks, they're an area that's extremely vulnerable to fraud and manipulation. People can pose as independent observers, then run up the price of penny stocks. All they have to do then is de list it, leaving buyer with nothing in what's classically called a pump and dump scheme.

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.