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How to Trade an IPO - 18433 views
BALTIMORE (Stockpickr) -- Few things capture investors’ attention like an IPO. Just think of the profits you’d have made if you were one of the first investors in Apple (AAPL) or Google (GOOG)!
In the real world, trading new offerings is a bit more involved than just buying on day-one and holding until you’re a millionaire. While the gains can be impressive in IPOs, you’ve got to know the trading dos and don'ts of trading them first.
In today’s Technical Primer, we’ll take a look at the factors that make trading an IPO unique.
An initial public offering, or IPO, is the process by which privately held companies become publicly traded. Statistically, IPOs are abundant when market sentiment is strong -- by waiting for buoyant market conditions, private equity owners are able to exit their investments at a substantial premium to less favorable markets. Despite the selling that we’ve seen in the summer of 2011, this year has actually been a strong one for IPOs. Already year-to-date, IPO transactions have increased by more than 33% over last year, as a number of high-profile tech names become publicly tradable for the first time.
Related: Does Technical Trading Really Work?
As tempting as it may seem, to treat an IPO name like any other stock trade, these “new” stocks are an entirely different animal. Limited trading histories, exaggerated supply and demand characteristics, and an increased speculation factor all mean that the rules are changed for trading IPOs.
That said, these volatile names can generate outsized returns for traders who plan their buying.
Generally speaking, fundamental factors (such as earnings, product lineups or cash in the bank) lead technical factors (a stock’s price action and trading characteristics). Those roles are flip-flopped for any hot IPO name.
Statistically speaking, IPO stocks tend to be newer companies with small-cap valuations -- two factors that dramatically increase the speculative forces that impact stock valuation. Because fundamental investors are paying for future performance in an IPO, subjectivity plays a much bigger role than it would in an established name, and volatility is increased.
Since fundamentals aren’t particularly useful for IPOs, technical analysis rules are the most important tools an investor can turn to when buying an IPO name. Keeping in mind a couple of key factors will greatly increase your gain potential.
Establish a Trading History
As tempting as it may be to buy a hot IPO name right out of the gate, don’t do it.
Unless you’re a full-time trader, buying an IPO on day one should be considered a speculative gamble, not a high probability trade. To analyze a stock’s technicals, it needs a trading history -- and those can only come in time. Why is a trading history so important to establish before you buy?
You can think of an IPO’s early price action as a way of feeling out the market for a stock. As prices move around, they’re identifying pockets of supply and demand for shares. Those initial support and resistance levels are crucial in forming a trading plan for any new issue. Keep in mind that your trading timeframe has everything to do with how much of a trading history a new issue needs to establish: barring any sort of definitive support or resistance set from the onset, I like to see at least a month of trading before embarking on a swing position in a new name; for daytraders, a couple of hours’ trading may be sufficient.
Ultimately, identifying those early support and resistance levels is key to profiting from IPO trades.
Related: Profit From These 3 Trading Mistakes
Don’t “Catch” Shares
All too often, would-be traders try to “catch” overbought or oversold conditions in a recent IPO stock. All of the contrarian rules that apply for regular stocks apply doubly for IPOs. To paraphrase a well-known market quote, subjective valuations can lead the market to put a ridiculous premium or discount on an IPO for much longer than most traders can stay liquid.
The trick to profiting from these kinds of moves is to be a reactionary trader. Instead of attempting to buy beaten-down IPO stocks with potential, or shorting overbought momentum names, wait for the reversal to actually take hold, then react to it.
Momentum indicators such as the Relative Strength Index can be useful to get cued onto the reversals ahead of time, but wait for price action to dictate actual entries.
There’s no question that IPOs are exciting investments. But add solid technical strategy to the mix, and the gains that can be found in trading these names have the potential to be very real. Next time, we’ll add to your technical repertoire with another primer that will bring you closer to implementing technical analysis for your portfolio.
In the mean time, do you have a burning technical analysis question? Get it answered by heading to Stockpickr Answers.
-- Written by Jonas Elmerraji in Baltimore.