The SEC currently defines a penny stock as any stock with shares trading below $5.00. However, since major companies sometimes offer stock for low amounts due to market capitalization, a common working definition of a penny stock is a stock with shares trading below $3.00 outside of a major exchange. They are often traded over-the-counter as pink sheets. The classic penny stock is issued by a small company with highly speculative shares.
Penny stocks are high-risk investments for many reasons. Since pink sheets are not required to file with the SEC, there is less information about them available to the public. Similarly, there are no minimal standards for staying on many smaller exchanges. Many penny stocks come form new small-cap companies without an established track record, or companies on the verge of bankruptcy. Penny stocks also tend to have low liquidity, meaning they will be harder to sell, with a low bid-ask spread.
Penny stocks should only be purchased by investors with high risk tolerance. Even then, it is usually best to invest in smaller stocks traded on the NASDAQ or AMEX rather then engaging in the OTC system. If you buy a penny stock, you must have realistic expectations that it may take a long time to grow.