IPO UniversitySelect Section
- Buying IPO Shares
- IPO Share Lock-up Expiration
- Quiet Periods
Making the Buy
After you have seen the roadshow, read the prospectus, and done your homework it's time to actually buy shares. We're not going to cover how many shares to buy here - that's a function of your portfolio strategy which we cover separately.
We're going to use a real example, Cardlytics (CDLX), to illustrate the techniques of buying shares in the open market on the first day of trading. An IPO is typically priced after the close of trading and allocated to accounts and customers. Many smaller firms and most individuals don't get direct allocations so they are left to buy on the open market. Typically an IPO will open for trading between 10 am and 11 am the next morning. After the allocations are made the lead broker collects a large number of buy and sell orders which collectively set the opening price of the stock - what we call the "first day open."
The uncertainty around where an IPO will open is what makes buying on the first day tricky. Shares can open way above their IPO price - some call this an "initial pop," others open "quietly" right at their IPO price, and some open up below their IPO price and quickly become "broken."
Before getting into more technical strategies it's worth noting that you can just wait until the shares open up and trade for a while and then decide what to do. The problem is that sometimes shares move very quickly and it can result in a missed opportunity.
To deal with this reality and also be positioned for the uncertain open I use a "limit order ladder" that gets set up pre-open so that I buy an amount of stock consistent with my view of valuation and upside opportunity. Even using this "limit ladder" approach, you have some risk. Especially since the "pop and drop" happens often when a stock opens up well above the IPO price. This encourages "flippers" who just sell their IPO allocations to make a quick profit.
Cardlytics (CDLX) is a company we did some work on and really liked. This is a stock that institutions like and our intrinsic valuation (IV) models suggest that the IPO price is a good entry point. Using relatively conservative assumptions the shares could appreciate to $28 over the next year or two versus the $13 IPO price.
The limit ladder strategy is to place multiple orders at different price levels. In our case, we selected $13, $15 and $16. A snapshot below shows the orders pre-open. It's important to determine the amount you want to buy at different price points. If the shares open at $14 or lower, all three orders would be filled. But if the shares open at $15.50 then only one order for a much smaller amount would get filled.
Here is what our limit ladder looked like pre-open:
Turns out that the CDLX deal didn't go so well. The shares opened below the $13 IPO price which signals that follow on demand is limited. This is probably due to market conditions given the DOW is having its worst week in the past 9 years.
Aggravating the short-term decline are the flippers who sell to limit their loss to a small one. Once the stock is under selling pressure it's a good time to sit back and wait for the supply to get exhausted.
If you look at the MORNING CHART you might see that there was some evidence of selling exhaustion and the price started to firm up. That's a fairly typical pattern. In this case, it wasn't an "all clear" signal as the shares lost momentum in the afternoon and fell back to $12.
During the trading day, we added some shares at or just below $12 which represents "support" in the trading world.
This is a stock we want to own for a year or two. We might "trade around" the position based on price action. It's often not worth the effort to trade a stock you don't have an abiding interest in.
Follow Up Actions
After the first day, cooler heads generally prevail and the stock direction will reflect more of what investors really believe. In the case of CDLX the next two trading days had consistent buying and pushed the price up to $18. The stock was also helped by good general market conditions which gave some buyers the "all clear" signal.
At this point there are three major things to consider: 1) pending stock coverage will come from the banks at the end of the "quiet period", 2) expiration of the share lockup agreements which will free up more supply of shares available for sale in the market and 3) use of stop-loss orders to protect gains.
About 25 days after the IPO the brokers who banked the deal will initiate research coverage. One can assume most if not all will be "buy" ratings so few care about the ratings themselves. But what write in the reports, where they set their price targets and most importantly, how they talk to clients, tends to help shares move higher amidst new interest.
As coverage day approaches we might take some follow up action on our position. If the shares decline ahead of the date, we might add with the expectation of being able to sell into greater demand post coverage. If the shares appreciate into coverage we might lighten up to lock in some short-term gains. That would also depend on the size of our position at the time.
Voluntary lock-up agreements are part of almost every IPO. The length of time is typically six months although it can be modified by the lead bank, especially if the company decides to do an organized secondary offering. Lockup expirations tend to put pressure on the stock price, even when it's a strong company. It's the first chance that venture capitalists, employees, and other investors have the opportunity to get liquidity. A certain amount of stock tends to be available "at any price" so it's a good time to buy or add to positions or exit one that you no longer feel as confident about.
Short sellers sometimes target weak companies just before lock-up expiration knowing that many will be eager to rush for the exits if the stock is down and the company isn't doing well fundamentally. To learn even more refer to our lock-up expirations page.
Once a position is established we manage it based on portfolio rules but it's also common to have some "automatic" protection against the shares declining too far. The most basic form of protection is to put "stop-loss" orders in place for the stock at some specific level. For example, CDLX has traded up to $18 from our $12 purchase price. We might want to set a stop-loss at $15 which would trigger a sale at that price or lower.
Depending on your broker you might be able to place a "trailing stop" order which "follows" the share price up and gets triggered once it goes down by an amount you specify.
In this case we might enter a stop-loss order at a limit price. In this case we'd chose something like $11.40 or $10.85. What that means is that if the stock trades at the limit price our shares get sold at the prevailing market price.
Stop-loss orders are useful in cases where 1) you want to enforce a sale discipline or 2) you have a day job and can't be ready to react to daily stock movements.
While offering protection they are automatically applied in situations where the market is overreacting to some event or news item. These could be situations where you might be wanting to buy more shares rather than sell.
Ladder limit buy orders can help you establish a position in an IPO during the first day of trading when prices swing wildly. Follow up actions around stock coverage, lockup expiration and price movements depend on your conviction level, current stock price and IV estimates.