What’s the Correct Way to Trade an Initial Public Offering?

Source: www.meta-formula.com

The initial public offering is a part of the market that always generates a great deal of interest, along with stories of fabulous profits and spectacular losses. But there are a ways to reliably profit on the initial public offering. Look for the trends that the initial public offering may cause and trade with them.

Initial public offering spinoffs are a solid trading trend to work with. A company that's going to spin off a part of itself as an initial public offering tends to move steadily up in price until the initial public offering date, starting a week or two before that date. On the day the initial public offering starts to trade, the parent company's stock typically dips sharply. The best strategy is to buy the parent once it starts moving in anticipation of the spinoff, sell it the day before the initial public offering is to begin trading, and then short the parent just after the initial public offering starts to trade.

Another trend to consider is the “quiet period” trend. The "quiet period" for the initial public offering is the twenty five days after a company goes public. During this time, the SEC forbids the company and the initial public offering underwriters to say anything that isn't covered in the company's prospectus or final registration statement. The underwriters face further restrictions on issuing any research.

As stocks near the ends of their quiet periods, they tend to steadily rise in price in anticipation of the "strong buy" recommendations most will receive from their underwriters after the quiet period ends. The run-up usually begins about ten days prior to the quiet period expiration, and is often accompanied by steadily increasing volume. It's wise to sell quiet period stocks the day before the recommendations come out. Why not hold the stock after it gets a "strong buy" recommendation? It's another case of buy the rumour, sell the news. It's also best to trade this trend with stocks that have highly respected underwriters and are in hot sectors.

Another solid trend play is to short stocks with upcoming initial public offering lockup expirations. An initial public offering lockup is a period of time, usually from six to eighteen months, when insiders who obtained the initial public offering at the offering price or less cannot sell their shares. Once this time period has elapsed, insiders often sell their shares. This trend is shortable because the greater the number of shares unlocked, the more likely it is that insiders will start to sell their shares, particularly if the market is not doing well but the share price is still higher than the initial public offering starting price. And the more shares freed, the better the chance of a negative effect on the share price. This trade works best when the number of shares being unlocked is more than 25% of the current market capitalization.

You should short the stock roughly ten days before the initial public offering lockup expiration date, since anticipation of the event usually scares traders out of the stock well before its actual date. Cover the short about five days after the expiration date. By that time, most insiders will seem to have sold, and the news will be priced into the stock.

Like any other trade, this one is not foolproof. Often one of the underwriters will upgrade the stock as the lockup expiration approaches, or the company will release news to boost the stock price to counter-act the selling. Be sure to check company news closely, since if the market is bad and share prices are down, lockup periods may be extended.

But when the initial public offering market is hot, a lot of traders buy into any new company. They commit a trading mistake that's like placing an overnight market order: They place market orders for an initial public offering before it starts trading on its first day, which leads to outrageous run-ups in price right when trading opens. For the trader, these orders are a sure way to lose money. Your order will end up being filled at a ridiculously high price that the stock may never see again.

If you're going to try to trade an initial public offering on its first day, don't place a pre-opening market order. Don't use market orders at all. The way to buy is with a limit order after the stock's price has pulled back a bit and is about to bounce and continue upward again. The goal is to buy at the bottom of the bounce, hold it as the price rises, and sell just as the price is about to fall again. You may be able to do this several times, until the stock's momentum drops. Remember, you can't short an initial public offering during its first thirty days on the market.

If you want to hold the initial public offering past its first day, it's hard to know exactly when to jump in, but wait until after the initial volatility has ended. The higher the initial public offering has opened the less chance it has of continuing to climb throughout the rest of the day. If the initial public offering has opened at an extremely high price, it will probably sink to a fairly stable level in an hour or two.

If not, and you think the price could go higher, you might want to buy fairly soon after the initial volatility has ended. One option is to buy half your shares and then wait to see whether there's a slump in the price later in the afternoon when you can buy the rest for less. The initial public offering can be incredibly volatile, and like with any other trade, setting stops is critical. But traded carefully, they are a consistent way to create trading profits.

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