Buying IPOs
Gaining access to an IPO in the primary market is seen as a real perk and is often offered to investors who hold bigger or higher value accounts in order to reward them for their business and their loyalty. Therefore, buying an IPO at the issue price or close to it is seen as quite desirable generally, and this is because in the short run at least, most IPOs tend to accumulate in value once they hit the secondary market.
This does not mean that all IPOs are going to perform this way though, and like all stocks, they must be carefully evaluated prior to considering trading in them, either buying or selling.
There are some particular features of IPOs that make them more likely to go up in price rather than go down, and therefore they can often be a better bet in the short run at least than your run of the mill mature stock.
With a normal stock in the secondary market, there are always buyers and sellers, there is always supply and demand for the stock in other words. When the demand exceeds the supply, the price goes up, and when the supply exceeds the demand, the price goes down.
An easy way to understand this is to imagine yourself looking to buy a lot of a company’s stock. At any given point in time, there will be people who will be looking to sell at a certain price. After you buy up all the stock at the current ask price, you will have to pay the next best ask, and you can move up the ladder through several price points once you complete your purchase.
The net result would be that you have driven the price up from your increased demand. The opposite happens when you are looking to sell a lot of the stock, where in this case the supply increases and overtakes the demand and puts the price down.
This happens collectively with all the orders for a stock in the market and this always sets the price for stocks at any given time. With an IPO, more people are looking to buy it than sell it, and those who bought it are less apt to sell it unless that price is high enough to motivate them.
This is why IPOs go up typically in the early stages, at least to the point where enough short term traders become satisfied with the profits that they have made so far and look to take these profits and exit their positions.
With normal stocks, this process will be subject to a number of conditions, but with an IPO, the anticipation of the price rising can become a self-fulfilling prophesy, because this may encourage more buying and less selling.
The Lock Up Period With IPOs
People who own the stock prior to its introduction in the secondary market, company insiders and investors, are prevented from selling their stock in the market for a period of time, usually between 90 and 180 days.
This is called the lock up period of the IPO and is designed to prevent the selling pressure that may result from this inside selling to depress the stock price.
If not for the lock up period, we may indeed see a lot of selling, as those who held the stock prior to the IPO often do want to cash in, and especially may be inclined to do so during the early stage of the IPO in the market.
This serves to stack the deck somewhat in favor of a more bullish move, in a situation where the atmosphere is usually already quite bullish. In order to best ensure that the party continues for a certain amount of time, the lock up period ensures that the supply isn’t going to be increased beyond what the company deemed should be included in the IPO.
The real risk here is that if insiders were allowed to dump their stock on the secondary market during this nascent period, prior to the IPO stabilizing enough, this could end up driving down the price of the IPO considerably more than the insider selling alone would, as many other investors would likely be taken along with the ride down.
After buying an IPO, many investors would quickly become uncomfortable if they saw the price drop significantly, and many would likely join the bearish party. This could create some very serious downward momentum in the stock price, something that most investors as well as those behind the IPO would not find favor with at all.
So, while it appears that this rule intentionally prevents market equilibrium and is biased toward the long side, stability is the main goal here, and the bullish favor is more of a side effect of this. It is a genuine effect though, and does help the stock rise more than it would otherwise to be sure.
The company also does not want to create the impression that company insiders have become so bearish on their own company that they are looking to get rid of it, as this may be interpreted as weakness. Perhaps in some cases it should be, but given that a lot of these insiders are merely looking to seek capital gains, in a way that they could not before prior to the company going public, the lock up rule seeks to prevent such misunderstandings.
IPOs are Also Difficult to Short
Shorting stock is part of the normal makeup of a mature stock on secondary markets, as people both place bets that the stock will both go up and go down all the time. While there is no particular rule against this aside from whatever rules may be present with short selling with stocks generally in a market, the nature of IPO markets in their early stages make short selling more difficult.
The main reason is that the desire to sell IPO stock in the early phase of its introduction to secondary markets with IPOs can be much more limited than you see with regular stocks. There are always bears present in a market and without people wishing to part with their stocks, trading would not occur, but when there are more people expecting a price increase than decrease, there will be less stock to borrow for the purposes of a short sale.
When we go short a stock, it does require that we borrow it from a broker who is holding it on behalf of other investors. If the demand for the stock is high, this inventory will be used to fill buy orders, and there may not be that much left to satisfy the demand of short sellers.
This also affects an IPO’s tendency to go up in price, as short selling pressure will usually offset buying pressure to a degree anyway, as one of the normal influences in the market. However, if a stock is rising and this is likely to continue, shorting is usually a very bad idea and those who have made a mistake here will end up adding to the demand and the upward pressure of the stock when they have to cover their positions to limit their losses.
So it’s not that there isn’t shorting going on with IPOs, but it’s harder to do, and those who do short it will often have to cover it and drive the price up even more. People are also less likely to short an IPO in the early phase since doing so would so often produce huge losses.
While IPOs are initially offered in the primary market, sold directly to investors in other words, it is when the IPO hits the secondary market that all the action takes place. This is where the rubber meets the road and is responsible for all of the excitement that is created with new stock issues.
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.
Contact Eric: eric@marketreview.com
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