How to Trade High-Profile IPOs

By Wayne Duggan

Initial public offerings (IPOs) give traders their first crack at exciting new companies. The IPOs, special purpose acquisition company (SPAC) mergers and direct listings of Robinhood (NASDAQ: HOOD), Coinbase (NASDAQ: COIN) and Airbnb (NASDAQ: ABNB) have been some of the hottest stories on Wall Street in recent months.

Unfortunately, investors aren’t typically getting in on the “ground floor” when they buy on the public market. And just because a company has a bright future doesn’t mean its IPO shares are necessarily easy money for stock traders.

Historical Data
There are plenty of IPOs that have been spectacular long-term investments, but studies have shown buying IPO stocks has historically been a bad move.

A long-term study back in 1991 by economist Jay Ritter looked at all 1,526 IPOs from 1975 to 1984. The study found 2 distinct trends. First, it confirmed the so-called “hot issue” market phenomenon. The “hot issue” phenomenon refers to the fact that IPO stocks closed their 1st day of trading up an average of 16.4% from their IPO price. The other trend Ritter found is that over the 3 years following their first day of trading, these IPO stocks underperformed a control group of similar stocks by about 27.4%.

A more recent study conducted in 2019 by Verdad Capital looked at the past 3,700 IPOs dating back to the late 1980s. Verdad found that the median return of those IPOs from the end of their first day of trading to the same date three years later was -31%.

But a more telling statistic from the Verdad study may be that plenty of IPOs performed much, much worse than a 31% loss. In fact, the researchers found that about half of those IPO stocks lost at least half their value over that 3-year stretch. Furthermore, about 1 in 4 IPOs traded lower by at least 75% during that time.

What Can the Average Trader Do?
Unfortunately, those historical trends leave retail traders with few options. Most of the time, the average trader is not allowed access to IPO shares at the IPO price. Those shares go to institutions and other high-net-worth individuals.

Robinhood was an exception to that rule given they allocated some IPO shares to their own users. However, if retail traders are allowed access to an IPO, there may not be the same mad scramble for shares on the first day of trading that typically drives the price higher. Robinhood is an excellent anecdotal example of that idea. The stock dropped 8% from its IPO price on its 1st day of trading, counter to the historical trend.

If you miss out on the IPO and the stock pops on its 1st day of trading, you could consider shorting it into the close of its 1st day. But there hasn’t been any major studies done on how IPOs trade on their 2nd day or even over the following week or month. That short trade may take 3 years to play out.

The only thing that seems clear from the historical data is that long-term investors shouldn’t typically buy on the 1st day a new IPO begins trading, especially if the stock opens significantly higher than its IPO price. If you’re looking to start establishing a long-term holding in a hot IPO, consider waiting a little while until the IPO volatility dies down and all the retail investors chasing the flavor of the week have moved on to another hot stock.

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