At some point following initial public offerings1 (IPOs), the stock's shares sometimes experience a drop in stock price as a lockup period ends, so it's important for investors to understand what a lockup period is, how it affects stocks, and possible ways to navigate it as an investor.
What's an IPO lockup period?
Some companies compensate their teams with large stock awards, but they don't want employees to sell large amounts of stock as soon as the company starts trading, so they implement a "lockup" period to prevent employees and other insiders, people close to the business, from selling their stock soon after the company goes public. Typically, lockup periods last between 90 and 180 days. Lockup periods are important for investors to monitor because the supply of stock available in the public market (known as the float) can increase significantly once insiders begin selling. Unless an accompanying increase in demand meets this new supply, the stock price could potentially fall, at least in the near term. In most cases, the lockup period is public knowledge, so investors know when the lockup period is coming to an end. As a result, stock prices might be influenced by the approaching lockup period expiration date. In some cases, the approaching lockup expiration results in some investors exiting their positions in an attempt to capture gains before the new selling ensues as insiders attempt to profit from their shares.
It's important to note that not all lockup terms are the same. For example, companies can lift lockup restrictions on shares early and announce additional shares not long after its IPO. Investors should always consider the potential for the lockup period and restrictions to change.
Before investing in an IPO, it can make sense to review the IPO prospectus to understand the terms and prepare for potential volatility if there's a lockup period. The SEC's EDGAR database offers company prospectus information which indicates whether the company has a lockup agreement, and when the lockup period ends. Understanding this information is important because a stock's price may drop in anticipation that insiders might start selling their shares in the marketplace once the lockup ends.
The risk of IPO lockups
Many investors choose to invest in IPOs because of potential early gains, although those gains are not a guarantee.
The expiration of an IPO lockup period may create an additional risk for the investors who hold the stock. Even for IPOs that have early success, as the end of the lockup period approaches, there is a chance prices could drop. The coming end to a lockup period means more shares could enter the market as insiders and others begin to sell. This increase in share supply can lead to lower prices, especially if demand for the shares drops at the same time.
Other risks of holding recent IPOs
The end of a lockup period isn't the only risk associated with holding shares of a company that recently made a public offering. Consider the following risks as well:
- Information about the company is limited since it's relatively new.
- There isn't an extensive price history to review.
- Without many analysts following the stock yet, there might not be much commentary on data.
- Limited earnings information and management information because there aren't past public reports to review.
For investors that like to have this information available as they research, not having it can feel like a risk.
Potential trading strategies for IPO investors
To help manage risk, some traders and investors turn to incorporating certain options strategies, while others might turn to using stock orders to exit their position if a certain price level has been broken. Options might be available to trade on a recently listed stock if the stock meets an options exchange's listing requirements and there appears to be overall market interest in trading options on that underlying.
Options carry a high level of risk and might not be appropriate for all traders. Additionally, Schwab customers need to apply to trade options and not all accounts are approved for options trading. Options-approved traders that are concerned about volatility approaching the end of lockup periods might consider the following strategies if the strategies align with their trading objectives and risk tolerance.
Strategy #1: Long put options
Long put options2 can potentially be used to help offset short-term losses. For example, an investor might be long on a recent IPO stock overall but worry that the end of the lockup period could result in a dip. By purchasing a put option on that asset, profits from the option can help offset losses in the underlying. A protective put3 option can potentially provide shareholders a hedge against a short-term dip, even if the investor is bullish on the company overall.
Strategy #2: Options collar
In addition to the stock an investor is seeking to protect, a collar consists of two options from the same expiration period: a long out-of-the-money4 (OTM) put and a short OTM call. An options collar is an attempt to allow the premium collected by selling the call to help pay for the cost of the put option.
Just as the put potentially limits risk should the stock price drop below the put strike, the short call might cap the potential profit on the stock above the call strike price. Think of the put as a "floor" beneath the stock and the call as the "ceiling." Where a trader chooses to put the floor and ceiling determines the overall risk/return of their position. The short call creates an obligation to sell the stock at any time until expiration. So for traders interested in continuing to hold their stock into the future, the risk of seeing the stock being "called away" must be considered.
Strategy #3: Stop order
A stop order allows an investor to potentially limit losses by selling a position if it drops to a certain price. This strategy might appeal to an investor who believes demand will be strong in the first days of an IPO. However, if the investor is incorrect and the stock price declines rapidly, a stop order can serve as a potential backstop. Entering a stop order does not guarantee execution at or near the trigger price, however. Once activated, the order competes with other incoming market order.
Understanding potential risks and how to offset them to some degree can help an IPO investor make decisions that potentially fit better with their portfolio strategy and risk tolerance.
1Initial public offering (IPO) is the process through which the shareholders of private companies first sell shares to outside investors (the public). Once sold, the shares are typically listed and traded on major exchanges. A company can use the IPO proceeds for corporate needs like expanding the business, funding acquisitions, or reducing debt, among other purposes.
2Gives the owner the right, but not the obligation, to sell shares of stock or other underlying assets at the put’s strike price within a specific time period. The put seller is obligated to purchase the underlying at the strike price if the owner of the put exercises the option.
3An options strategy intended to guard against a certain level of loss while not limiting upside gains. The shareholder pays for the put in exchange for the stock price protection, , which increases their overall costs, but is done to potentially limit the losses if the underlying security declines in value.
4Describes an option with no intrinsic value. A call option is out of the money (OTM) if its strike price is above the price of the underlying stock. A put option is OTM if its strike price is below the price of the underlying stock.
Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the options disclosure document titled Characteristics and Risks of Standardized Options before considering any options transaction. With long options, investors may lose 100% of funds invested. Investing involves risks, including loss of principal. Hedging and protective strategies generally involve additional costs and do not assure a profit or guarantee against loss.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.0723-31YN