How to Trade IPOs for Beginners

Initial Public Offerings (IPOs) are the entry point for any company to be listed on the major stock exchanges. For investors and traders this represents an opportunity to get in on the ground floor of promising companies looking for public investment. But, trading IPOs can be a high-stakes game, as the rewards are matched by the risks.

How an Initial Public Offering Works

An IPO is the process through which a company transitions from private ownership to public ownership. Once a company has made the decision to look for public investors there are a few key steps that take place in conjunction with investment banks to bring their “product” to the market.

  • Preparation: The company decides to go public and selects underwriters, typically investment banks, to manage the IPO process.
  • Registration: The company submits a registration statement to the Securities and Exchange Commission (SEC) containing information about its financials, business model, and risks.
  • Quiet Period: A “quiet period” follows, during which the company, underwriters, and insiders are prohibited from promoting the stock.
  • Roadshow: The company embarks on a roadshow, where it presents the stock to potential investors and gauges demand.
  • Pricing: The underwriters set the IPO price based on demand, often balancing between securing capital for the company and offering attractive returns to investors.
  • Trading: Finally, the stock becomes tradable on an exchange, and investors can buy and sell shares.

How to Buy an IPO

To participate in an IPO, you’ll need a brokerage account and the ability to fund it with how much you plan to invest in the company. However, actually buying IPO shares at the list price can be challenging due to high demand. If the IPO was heavily marketed its very likely that at the time of open, if investors are bidding for shares, the spreads will be wide and you’ll potentially not get filled.

Trading Strategies Around IPOs

Remember that just because an IPO is coming to the market at a certain valuation, does not mean that its actually worth that much. If the public market perceives the value to be below, prices can easily drop if there is no interest on the open. Alternatively if its perceived as undervalued, you better believe bids will be flying.

In recent times, IPOs have also acted as a way for founders and insiders to get exit liquidity. If you see large institutional selling as soon as the list opens… you can bet, insiders want to get paid and want to get out. Generally a bleak indication of optimism for the company.

For all of the reasons above, its critical that you approach trading IPOs with a full toolbelt of strategies. Maximum flexibility is required to navigate these listings successfully. You should already have a foundational understanding of technical analysis, but here are some additional points for IPOs

Trading the tape: Because there are no historical price levels to use as a gauge, you’ll need to know how to read time and sales to get a grasp on order flow and any indications it is showing. Are there deep bids? Thin asks? Are buyers lifting the offer? Or is it the opposite with sellers hitting the bid? Only level II price data can help you in the initial frenzy of IPO trading.

Pullbacks: Once the IPO has been available for a few hours the volatility should settle just a bit. Nothing major, but enough to assess on the intraday time frames where you can position against for tight risk reward. Because IPOs have a boom and bust history, its best to make sure that you figure out exactly where your stop loss is going to go before placing any trades. Scalps or otherwise.

Longer timeframe: For players on the longer timeframe there are three key levels for any IPO trader. The opening price, the high and the low. If we are below the opening print, the next buy setup is a long through the opening print with a target at the high and then looking for continuation. If we are above the opening print, the breakout is making a new high. Generally speaking, shorts are not available on IPOs because brokers don’t have shares to lend and options take a few weeks to list if eligible.

Do IPOs Always Become Profitable?

IPOs do not guarantee profits. While some IPOs skyrocket, others completely bust. The profitability of an IPO depends on various factors, including the company’s fundamentals, market conditions, and initially investors and traders sentiment. An infamous example of an IPO that has gone bust is ETSY, listing at $31 and falling to a low of $6 before taking three and a half years to get back to $31.

Conclusion

Trading IPOs is a shiny object that can oftentimes be more distracting than profitable for investors. With the right strategies and careful consideration, IPOs can become a rewarding part of your trading portfolio, but likely only in moderation.