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How to Trade IPOs, Short- or Long-term

Learn how to research IPOs and what techniques may work for either short- or long-term strategies.

When a privately held company offers its stock to the public for the first time, it does so by means of an Initial Public Offering (IPO). There can often be considerable excitement surrounding the release of an IPO, as investors feel the allure of getting in on the “ground floor” of a new opportunity. Generally, private companies will work with an investment bank to set the price of the shares and market them to interested parties. This initial offering of shares directly from the company’s underwriters is called the primary market. Generally it is difficult for retail investors to obtain shares from the underwriter at the initial offering price. The next best thing for many traders is to buy shares as soon as possible after they start trading in the secondary market on either the New York Stock Exchange (NYSE) or NASDAQ. If you want to wade into the new offering pool, here are some things to consider.

Gauging initial demand

Check to see if the new offering is substantially oversubscribed and priced at the top end of the initial negotiated price range. These factors often indicate a strong demand for the shares that can help support the stock once it begins trading. You can get the details by doing some research. Both the NASDAQ and NYSE websites list upcoming IPOs and their initial price ranges and anticipated release dates. Also, reading media reports can give you an idea of whether the offering is going to be oversubscribed, and by how much. The demand is generally expressed as a multiple of the sharers offered. For example, a news story might report that the IPO is five or ten times oversubscribed, indicating strong buying interest.

Entry techniques for short-term trades

Determining the ideal time to actually enter into a new offering trade depends on your time frame. Let’s talk first about entering on the first trading day for a quick single session trade. Figures 1-4 below show the charts for four different new offerings on their first day of trading. Each candlestick represents a five-minute timespan.

Figure 1 SSEdge July 2015

Figure 2 SSEdge July 2015

Figure 3 SSEdge July 2015

In the first few minutes after the open, new offerings generally follow one of two paths in the secondary market. Some stocks shoot up for the first 15 to 20 minutes as eager buyers start chasing the stock. (Figures 1,3 and 4) Others will start trading down immediately, as nervous shareholders who bought in at the negotiated opening price don’t see any immediate follow through and sell shares to lock in minimal gains and ensure loss prevention. (Figure 2) It is often quite difficult to know which route the stock will follow. What seems clearer, however, is that regardless of the stock’s movement in the opening minutes, there is a tendency for the stock to pull back and achieve a low somewhere between 30 and 60 minutes after the opening trade. To avoid this sort of limbo, some traders will watch the five-minute bars during the pullback period, buying when the closing high of the current five-minute bar is greater than the peak of the last five-minute bar. A reasonable place to put an intraday stop would be under the low of the pullback period.

Longer-term strategies

If you have a longer time frame, you might not want to buy on the first day. Often, new issues drop in price after the first trading day as the initial hype subsides. Figures 5 and 6 show two of the new offerings we looked at earlier in the days after their debut (hourly charts).

Figure 4 SSEdge July 2015

Figure 5 SSEdge July 2015

Some traders will wait several months before they consider buying a new offering. One reason is that they want to see how the stock performs after the initial lock-up period ends. During the lock-up period, underwriters and company insiders are prohibited from selling. When the lock-up period ends, they can flood the market with shares, causing the price to drop substantially. If, on the other hand, they don’t sell too much and the stock continues to hold its value, it could mean that they are optimistic about the long-term prospects of the company, a generally bullish indication. Lock-up periods typically last 180 days, but can be as short as 90 days or as long as 1000 days, so it is important to check the specifics. Some traders consider longer lock-up periods a show of faith in the company’s longer-term prospects by insiders.

Another reason to wait is that many traders want to see how the stock behaves after its first earnings announcement as a publicly traded company. Often the underwriters and their analysts make very optimistic projections about the companies’ potential earning as they promote the deal. Waiting to see what the earnings actually are can provide a more realistic picture of the company’s performance. Taking a position right before an upcoming earnings announcement is often a high risk, high reward strategy as new offerings tend to be quite volatile post earnings. Finally, after a few months, there can be enough price and volume data to locate support and resistance levels. Often, new offerings will form some type of base several weeks to several months after going public as the forces of supply and demand slowly balance out. Many traders wait to see if the stock can break out of this base before buying. A breakout through resistance, especially on above average volume, signals a return of healthy buying interest and the market’s renewed confidence in the company’s prospects. (see Figure 6).

Figure 6 SSEdge July 2015

Trading new offerings can be an exciting proposition. But no matter what time frame and approach you choose, have a risk management plan in place and stick to it.  

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