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The Art of Trading an IPO

T3Live.com
Fri Feb 07, 2014 03:34 EST

IPOs represent tremendous opportunity but also significant risk. If you are going to invest in or trade a stock on the first day of its IPO, it's paramount to have a plan.

Technical analysis is the study of price changes in an asset over time. Price changes occur due to forces of supply and demand. So, in essence, technical analysis is the study of how the supply-demand relationship has evolved over time.

On the first day of an IPO, the forces of supply and demand are in their most raw form. There are no prior support or resistance levels, there are no patterns on the daily chart, and there is no short interest. Because stocks are in their most primitive form on Day 1 of their IPO, using intra-day technical analysis can be extremely valuable.

Given that you can't short IPOs, a trader's job is to figure out whether a new issue is worth buying for a short, intermediate, or long-term trade.

Before the IPO comes to market, there are two main factors to consider: the number of shares being offered (size of the float) and the valuation range of the company. Both factors play an important role in how an IPO trades in its early days.

The size of the float is important because it represents supply. The smaller the supply, the greater the demand could be for shares. Demand is also affected based on how the valuation metrics stacks up relative to industry peers. If an IPO is priced conservatively, below or on par with multiples from similar companies, demand could be higher, and vice versa. Based on real demand in the marketplace, a stock's IPO price can also be raised or lowered in the days leading up to the offering.

While analysis of the float and valuation can help you be prepared for IPO day, they are ultimately subjective measures. The full story is told once the stock opens for trading.

We teach a strategy called the "The Art of Trading Day 1 of an IPO" in order to teach you how to manage risk and potentially profit on Day 1 of an IPO.

The first step is measuring initial demand. You get a pretty strong indication of how an IPO is going to fare in the first few minutes after it opens for trading. A good IPO should generally increase in price immediately after it opens, but it's important not to blindly chase. That's where "the art of the first day" comes in.

One of the best lessons a professional trader or investor will teach you is "never chase." Even if you love a company or stock, only buy it if the price is right. The same applies for IPOs. If the price of an IPO runs away from you before you can get involved, so be it. We look for calculated opportunities to get involved where you can define your risk.

When an IPO opens for trading, we look for a range to form after the initial move. The formation of a range allows the stock to absorb the selling from "flippers," or investors who received placement of IPO shares and then look to immediately sell. If a stock can hold in a base during that initial phase, it is a positive sign.

Once the range is formed, we look for potential entries based on patterns on a short-term chart (you can use anywhere from 1- to 5-minute charts) or pivot highs. Entering the trade through a defined technical level allows you to place your stop at a defined level within the pattern as well.

You can apply the same level versus a level strategy throughout the day. Whenever a stock puts in a new range, you could use the top end of the range as a trigger, with related pivots as your stop-loss.

Chasing an IPO based on the hype is never a sound strategy. If you are going to get involved with a new issue, make sure you do so with a plan centered around risk management.

Editor's note: This story by John Darsie originally appeared on T3Live.com.

To read more from T3Live, see the following stories:

Market Retests Broken Intermediate-Term Trendline Ahead of Jobs Report (Morning Call)

Daily Recap: February 7, 2014

Market Looks to Build on Small Red Dog Reversal (Morning Call)


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