Risks of Trading IPO Stocks

Risks of Investing vs. Trading IPOs

In spite of all the risks of investing, it does embrace the virtue of simplicity, and this is a very important and valuable component of any trading and holding of financial securities, and is generally very underrated.

There isn’t anything simpler than deciding to purchase a stock such as an IPO and just hang on to it indefinitely, and without any exit strategy at all, there’s nothing to mess up. Sure, the investment may not turn out to be a good one, but at least if we do nothing we are not adding to whatever problems it may have.

Simplicity in itself, as important as it is, isn’t enough, and this strategy is completely inflexible and unable to adapt at all to changing conditions. Conditions do tend to change quite a bit and ideally we need a means of adjusting our views and tactics when appropriate.

Risks of Trading IPO StocksThere are therefore two main types of risk in both trading and investing, the risk that one’s position may go against you and the risk that you may make trading mistakes.

When we trade, we seek to not only increase our potential returns, but to also reduce the risk of positional losses. This requires us to trade well though, and in particular, to avoid making trading errors that may end up adding up to more than the risk that we seek to avoid by exiting positions with smaller losses than can rack up with investing.

Mistakes in trading can take several forms, but are mostly a matter of either hanging on too long to a position, or not hanging on long enough. There’s also the risk of having our trading costs, primarily commissions paid to brokers and paying spreads impact our results too much.

This does not mean that it is better in itself to trade less frequently, but when we trade more frequently, we need to at least see enough additional profit by doing so to make up for these added costs.

Trading stocks, which always involve paying both a commission and a spread, are particularly prone to overtrading, and overtrading is a matter of our not satisfying the criteria of benefiting more and not less from further trades.

Investing therefore is less prone to mistakes and also involves a minimum of trading costs, although we need to be aware that hanging on to investments too long is in itself a mistake and often an expensive one.

Investors though are even more prone to actual trading mistakes though, as are newer or unproven traders as well, and need to be careful when coming up with strategies to manage their positions so that they don’t end up hurting themselves rather than helping themselves.

Volatility Risks with IPO Stocks

The more volatility we have with a security, the more likely that we will make mistakes, and the more these mistakes may end up costing us. Even instruments that do not move much at all over a given period of time can provide quite a bit of volatility risk to traders. If an IPO is trading in a range for instance, one may buy at the top of the range, sell at the bottom when the trade stops out, and go back and forth this way and lose quite a bit of money over many trades.

IPOs are known more for their upward movement, although in shorter term time frames, they can certainly trade in ranges as can any security. We need to be careful with range trading and in particular make sure that the ranges we trade are wide enough, as well as looking to target the right side of the range and look to capitalize.

IPOs do go up faster than normal stocks and also can go down faster as well, as people take profits at certain times. This is the real risk of added volatility, that a position may move against you and you are too slow to react and incur greater losses than you should have.

Any time that we wait too long to exit positions, there is also the risk that we may be exiting at a time where a reversal is more possible, and the more a position moves in one direction, the more likely that it will reverse, generally speaking.

This is particularly true with IPOs in their early stages, with their biases toward the long side, and at some point when those seeking to sell their positions peters out, people will step in and buy these bottoms and reverse the trend.

Institutions who are looking to acquire large amounts of an IPO stock are particularly watchful for pullbacks, as they see this as an opportunity to reduce their average cost per share, and generally don’t just bid up a stock in order to fill their orders.

This means that when an IPO experiences a pullback, it’s even more likely to reverse when it is under accumulation, and this is why a lot of people choose to hang on to IPOs in the early stages and give them even more room than they normally would with a stock.

The Risks of Missing Out on IPO Reversals

Even short term traders need to be prepared to give IPOs a little more room, and the risk isn’t just how much you may lose on a trade, it’s also the risk that you may not get back in at the right time when things do turn around and the IPO starts moving in a positive direction again.

For whatever reason, people are more reluctant to re-enter trades even when it is clear that their exit was a mistake and they should be back in the position. As the wisdom of such a move becomes more and more clear, people will often still stand down and beat themselves up for making the mistake of closing it without properly considering what the best way to go now is.

This is especially a risk with IPOs, as they often do just pull back a bit and then keep going up more so than normal stocks tend to do. Exits therefore need to be well planned, and even more so than it would be required with established stocks, and we also need to plan our conditions for re-entry well.

In particular, we cannot be reluctant to re-enter an IPO on the long side when the overall tendency to the long side is significant, which is often the case with IPOs and is their distinguishing feature during the run up period and in any period where the market for the IPO remains bullish overall.

This is one of the biggest reasons why IPO trades require more room and one needs to make sure that the amount one is risking with the trade is appropriate for one’s overall trading capital, which should have us trading with lesser position sizes with IPOs than with normal stocks in order to compensate for this.

This may seem like a step in the wrong direction, where we’re seeking greater profit potential per share but trading with less shares, and this may even have us wondering what the advantages of trading IPOs actually is.

There are still advantages though, and this is a lot like looking to not over-leverage with a trade, even though the profit potential may be greater. When the risk is greater though, we need to make sure we can still manage it, and leveraging can be a great way to increase one’s return, but only provided that we can manage the risk properly.

Both can be accomplished though, and the same thing applies to trading IPOs, and the adjustments downward in size need not even be that significant, just enough to allow us to take our normal amounts of loss risk and still have ourselves in a position to not get stopped out too soon too often.

Emotional Risks with IPOs

Emotion can influence trading quite a bit, and in fact, the downfall of traders tends to be due to their trading based upon emotions too much and not enough on reason.

The two emotions that affect traders the most are greed and fear, and greed in particular can be a problem with trading IPOs. Since there is more upside potential with IPOs, people may end up getting too excited about them and place their fates too much on hope, hope that the trade may deliver on their high expectations, and this can cause them to persist in trades longer than they should.

Hope has no place in trading, or in investing for that matter, although with investing, hope is far less prone to dash our strategies, especially when there are none in place to dash. This can be an issue if a position goes well against an investor, to the point where they may second guess themselves, and at this point hoping might prevent them from cashing out when that would be the best choice for them.

Hope and trading really don’t mix, and fear and greed can be especially harmful, given the much higher likelihood of traders to act upon these impulses and make mistakes as a result.

We trade based upon objective criteria, and when this criteria is satisfied or is violated, this is what we need to base our decisions on, not emotion. When something like an IPO comes with vaulted expectations and also tends to move more as IPOs do, the danger of trading based upon emotion becomes more of a risk.

All of the pitfalls of trading stocks are in play with trading IPOs, and they tend to be even more amplified due to the nature of the greater volatility and lesser market knowledge of these newer stocks. This can be muted and even well compensated for by looking to take advantage of the longer term upward bias that IPOs tend to have generally, but this does require skill to manage, and in a real sense, different skills than are required in stock trading generally.

If the IPO issue is a new one, and one does not have the normal ability to short the stock, this can make things even more difficult, as we now cannot just ride the trend and have to wait until things stop going down in order to get back in sensibly.

With all this said, IPO trading can certainly be lucrative and even superior to trading established stocks, but at the same time we need to be aware of the additional risks that are present in these trades and not let our excitement interfere with our decision making.

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.