Advantages of Trading IPO Stocks

IPO Stocks and Initial Long Bias

IPOs are structured to gain value in their early life and this is exactly what those who have purchased the IPO, as well as those holding shares that have been converted from private to public, want to see.

Normally, the price of shares is exposed to free market conditions, which involves the ability of traders and investors to take long and short positions. It’s not that short selling of an IPO isn’t permitted, it’s just that it is hard to do, because this requires brokers to lend stocks from their inventories which are very limited initially.

Advantages of Trading IPO StocksWith so many people typically looking to buy an IPO in its early stages, the inventory of stock that can be loaned to short sellers is very minimal, and those looking to trade the IPO usually aren’t well advised to short them anyway, although there are certainly exceptions.

There’s also the lock up rule, where selling by company insiders isn’t allowed, and this certainly does serve to artificially create a bias toward the long side as well. Once the lock up period expires though, all bets are off, and these people have been waiting a long time to sell and many do liquidate a significant portion of their stock and receive a big payday once allowed.

Prices move up by the forces of supply and demand, and during the lock up period, supply is reduced, allowing demand to rule more, and after it, the supply is increased and can drive the price down all by itself.

Along the way, the momentum created by the artificially high ratio of demand to supply can make trading IPOs on the long side quite attractive, due to the greater reliability of the trades in this environment.

IPOs often will hit the ground running, and traders who wish to ride the wave can see themselves realizing significant gains, either during this period, or on shorter term time frames where they look to take advantage of shorter term moves up, and perhaps look to get flat on the company during pullbacks.

Nothing goes straight up of course, and there are always dips even with stocks that shoot up quite quickly, and the trader has the ability to pick and choose their spots that they want to be in a stock. This also applies to shorting as well, although once again, shorting really isn’t much of an option at this point in time, although once we get past the lowered supply it certainly is.

More Volatility from IPOs Mean More Potential Profit

Traders love volatility, at least to a certain point, a point where the risk of it can be managed well enough to provide an overall picture that will be profitable more times than not with a given trading strategy.

Stocks move up in price from the stock being accumulated, and move down in price from the stock being distributed. While all stock trades involve a buyer and a seller, it is the changes in demand from the public, including individuals and institutions, which determine whether a stock is under accumulation or distribution or flat.

IPOs clearly involve a period of above average accumulation, even though the amount of stock placed in the market is a fixed one. As people buy the new stock, it does change hands from those willing to part with them to those who wish to own the stock, but a lot of this stock buying isn’t for trading purposes, it is directed at longer term holdings.

Since a lot of this stock buying is designed to be held for longer periods, which is the case even more with IPOs than with normal stock, this does serve to drive the price higher, and also insulate against shorter term pullbacks, which dampen longer term enthusiasm less. Traders may exit when this happens, but the investors are staying put, and therefore a higher proportion of investors to traders will add stability to the movement up that we often see with IPOs.

IPO Trading and Predictability

While greater volatility is a desirable component of a trade generally, it’s not so much the volatility that matters, as the predictability of the move matters even more, and this is actually an essential feature of a good trading opportunity.

When we look to predict the direction of a stock or other tradable instrument, we need to look at both the potential for a move and the likelihood of it happening. The more predictable a move is, the better it is, because this means it will work out more often than trades with lesser predictability.

For the most part, IPO trades do tend to be more predictable in the early stages, due to people flocking to buy it and a lot of shares that would otherwise have been sold by insiders being kept out of the equation.

Quite a few professional stock traders pay a lot more attention to IPOs than normal stock to seek out trading opportunities, and while not all IPOs present good ones, a higher percentage of IPOs can versus more established stocks.

It’s not that traders can just jump on IPOs with no real regard to their trading potential, and traders still need to apply whatever techniques they normally use to determine whether a stock represents a good trade at any point in time, but given that often times these trades are both more reliable and more lucrative, they are certainly at least worth a good look.

Exiting IPO Trades

What separates IPO traders from IPO investors the most is where we plan to exit the IPO. Investors may or may not have an exit plan, and more often than not IPOs are just bought with no real idea of when the investor will get out, which may come down to the point where the investor becomes unsatisfied with the IPO’s performance that they dump it.

Traders, on the other hand, typically plan their trades and especially their exit points, where certain conditions will indicate that it is time to close their positions. IPOs do also attract a different sort of trader than those who usually trade stocks, who are known as flippers and view this investment similar to those who buy a house and flip it for a profit.

So called flippers generally aren’t as well versed in trading as actual traders are, although they certainly should strive for this, as trading is purely a game of skill and one’s fate depends upon it on the long run. Often times, the exit strategy with flipping IPOs is more of a subjective one, where one for instance may feel that it is time to go, but this is not something that should be left to intuition unless one is very experienced and gifted at using this, which these traders generally are not.

Traders rely on more objective standards than this, at least the successful ones, and this comes down to setting conditions which would make the trade holdable and ones that imply that the prospects of the trade working from here have deteriorated.

Traders measure the effect of the supply and demand of an instrument which is manifested in changes in price momentum. The fact that IPOs do tend to have good momentum to the upside is a benefit for sure, but this momentum cannot continue on forever, and there will be a point where the trader’s capital will be more suited somewhere else. Closing trades by traders don’t just mean that the trade has necessarily reached its failure point, it’s more that the projected return on investment has subsided enough.

Often though, and most often, this does mean that the expectation has reversed, as for instance with a long position more likely to go down than up over a given time period. Traders look to shorter time periods, and whether or not the price will be higher in a year or two isn’t even relevant, it’s where it is heading now that matters, in the near term.

The goal of all traders is to flip positions and look to make money out of their trades this way, and while many trades don’t work out, if one can make a net profit from this, one is trading successfully. With IPOs, this means riding the waves up in the early stages and getting out when the demand slows down to the point where the sellers are now taking over more.

What it Takes to Trade IPOs Successfully

Given that IPOs do tend to be more volatile than more established stocks, while IPOs do provide greater potential for profits for traders, they also involve more risk, and this risk does need to be managed.

Traders manage risk two ways, by managing their position size and managing their time frames and exits. Shorter time frames involve less risk but also less potential for gain. A larger position may provide for a greater potential for gain, but in order to seek that additional gain, one must also be prepared for bigger losses as well.

If a stock moves more in either direction, in other words if it is more volatile, it may not just be a matter of setting a certain amount that one is prepared to lose and do so in the same way one would do with an established stock.

There are two types of stops, ones involving a certain amount of loss, as well as technical stops, and technical stops are superior, but they cannot involve one losing more than one should on a trade.

For example, successful traders will generally risk no more than 1-2% of their capital on a single trade, but with greater volatility, this does need to be adjusted upward by some means. If not, the more volatile IPO may stop us out with moves that are, for the stock, less meaningful and should have been ignored.

We can’t risk losing too much on a play though if we want to stick around, or have the risk of being hurt too high, so the only sensible way to manage this is to downsize our position size with IPOs.

Beyond this, trading IPOs isn’t really that different from trading regular stocks, and all trading involves discovering favorable probabilities based upon a set of conditions and then executing the plan properly to take advantage.

If one is already a good trader and decides to trade IPOs, and does so with an appropriate amount of care, then trading IPOs can be a great deal overall. Like all trades, we’ll win some and lose some but the plan is to be up enough overall on these, but that is certainly attainable if we have the skill.

Investors should be careful with looking to trade IPOs without a sufficient understanding of how to trade, especially those who seek to trade off the cuff, which is a prescription for losing overall, especially if one is not sufficiently experienced in doing this.

On the other hand, investing in IPOs with no plan isn’t the best way to go either, and if an investor does have an exit strategy and it’s at least a decent one, then this can be the better option, even though one may not be that experienced with these things. Keeping in mind that the idea is to make money when something goes up and be out of it or short when it goes down, as long as we base our decisions upon the performance of the IPO, we’re at least facing the right direction.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.