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Trading

IPO Fever: Trading on Initial Public Offerings

Katya Stead
Financial Writer
Sep 18, 2023
Initial Public Offerings - or IPOs - represent a unique opportunity for traders to speculate on stocks with a lot of market activity and hype surrounding them. To learn about the IPO market, read on.
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What is an IPO?

The acronym ‘IPO’ stands for ‘initial public offering’, and it refers to a privately-owned company that has decided to become a publicly traded company. A company debuting or about to debut on a stock exchange is called an ‘IPO’. This is an opportunity for traders to speculate on that company’s share price, and investors will be able to buy its shares, for the first time.

While becoming a public company is a process, the term ‘initial public offering’ usually refers to the date that the business will officially be listed on a stock exchange, which is considered their ‘market debut’. For this reason, another term for an IPO is ‘ a stock launch’.

The process of going from private company to IPO

Going public can be a lengthy process. Before becoming an IPO, the business will need to be evaluated by an external party to determine what their ‘IPO price’ should be set at.

This will be done by investment banks, underwriters and/or any venture capital investors the company may have. As part of this valuation process, these parties will help the company to determine the date they should aim for to launch as an IPO, as well as determining the level of interest in the offering and potential demand for IPO shares once it goes public, which helps to determine the IPO market price.

The business will also need to meet all the requirements regulations for a public company of the country and exchange in which they wish to be listed. In the United States, for example, this is managed by the Securities and Exchange Commission (SEC).

Why do companies go public?

There are many reasons companies may wish to launch an IPO. Some of the most common include:

  • Because IPOs are the event at which their shares are first offered, companies gain capital by going public
  • For the same reason, it’s also often a great metric by which to measure a company’s market desirability, public image and general popularity by looking at how in demand their shares were on the IPO launch day, which results in the initial valuation of the company
  • For companies that have been smaller ‘mom and pop shops’ for a while, becoming a publicly traded company can confer a sense of legitimacy and of having ‘made it’
  • IPOs are news, and so having a well-publicised launch on an exchange can give the company some publicity and thereby visibility
  • There are often several behind-the-scenes institutional investors in a company before it goes public, such as venture capital firms and lenders like banks and angel investors. Their investing into an IPO launch also adds a capital injection into the business
  • But how do these initial investors recoup their investment? The capital raised at an IPO may be used to provide this - and these individuals may even sell their privately-held shares at the IPO to make a profit

All this being said, it’s important to note that being an IPO is not a requirement to being a company - unless you want public market shareholders and investors and to be publicly traded. There are many examples of businesses - even some blue-chip companies like Bloomberg for instance - that are still privately owned.

The different types of IPOs

There are three main types of IPOs:

  1. Traditional IPO - The most common way to go public, this involves the steps we mentioned above, in terms of getting valued (and often invested in) by venture capitalists, investment banks and underwriters. Often, this prior step with lenders provides the capital needed to fund the process of going public.
  2. Direct listing on an exchange - This is the least bells-and-whistles IPO, and involves the company directly debuting on the stock market without an initial funding round with lenders first. It’s uncommon, as it generally means the company must have deep pockets in order to afford the IPO on its own.
  3. Special Purpose Acquisition Company - SPAC for short, this is a more indirect method, but still an increasingly popular one. With a SPAC, the business merges with another company, then publicly launches as a collective shell company.
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Why are IPOs important for traders?

The launch of IPOs are an important opportunity for traders to speculate on stock prices in two principal ways. Firstly, IPOs (particularly higher profile ones) almost always come with a certain degree of market interest guaranteed. With more prospective buyers and sellers, that means there’s more opportunities to make a profit (or a loss) for traders.

Secondly, IPOs that are high-profile enough will have what is known as a ‘grey market’ as well. Grey market IPOs are chances for traders to speculate on what they think the IPO share price, and initial market cap, will be at launch before the time of the IPO date. This is another opportunity to potentially make a profit (or a loss) off of an IPO launch as a trader.

That being said, it's vital to note that there are additional risks to speculating on IPOs for traders. IPOs can be very volatile and difficult to predict, as the company has never been public until now and is something of an unknown quantity. A botched trading debut, for example, could result in significant losses for traders.

Also, remember that an IPO company's value and worth is still being determined during the IPO launch stage, which means normal trader due diligence like conducting fundamental analysis and technical analysis isn't really possible.

For this reason, traders of IPOs should not be beginners and should have a decent appetite for risk, as well as a good risk management strategy in place.

How to gain exposure to IPOs with Pepperstone

When trading with Pepperstone, you won’t invest in an IPO company directly. Instead, you’ll use financial derivatives called CFDs to speculate on their share price as an underlying asset once they are publicly traded.

This is important to know, because with CFDs you can go long if you think the new company’s share price will rise, but can also go short if you think it will fall instead. With the volatility and unpredictability associated with IPOs especially, the ability to short-sell can be very advantageous. If you’re correct in your forecast, you’ll make a profit, but will make a loss if you’re incorrect.

However, it’s important to note that CFDs are complex financial instruments which are leveraged. This means that, instead of paying the full amount of your position upfront as you would when investing, you’ll put down an amount called margin upfront, which is a fraction of the value of your trade. However, risk comes along with benefit, as both profits and losses are based on the full position size, not your margin amount.

In conclusion: the TL;DR summary

IPOs represent a potentially rewarding opportunity for stock traders to speculate on a market with significant volatility, market activity and general interest. However, they are not without risk and are perhaps not for beginner traders or those without a well thought-out risk management strategy and IPO trading strategy in place.

FAQs:

What does IPO stand for? What is an IPO?

‘IPO’ stands for ‘initial public offering’. An IPO is a company that was previously privately owned becoming a public offering listed on an exchange. At their stock market debut and just before it, this company is referred to as an ‘IPO’.

What is a SPAC? How is it different from an IPO?

A ‘Special Purpose Acquisition Company’ (SPAC for short) is similar to an IPO in that it’s also launching publicly on an exchange, but the process is different to a traditional IPO. With a SPAC, the business merges with another company, then publicly launches as a collective shell company.

Who is IPO trading best for? What trader will it suit?

Because IPOs are companies whose stock is as yet untested, but still enjoys a fair amount of activity and interest usually, it can be very volatile. Also, it’s important to note that trading on IPOs can carry more risk than other stocks, because they are less established companies, with less data and no chart histories to study. This means they are perhaps not for beginner traders or those without a well thought-out risk management strategy and IPO trading strategy in place.

What risk management protocols should ideally be in place when I trade on IPOs?

Traders who do want to speculate on IPOs are more likely to lock in their successes, and limit any potential losses, by keeping their position sizing and leverage ratio conservative, as well as ensuring they have stop orders and limit orders in place.

hello from MISKOLC

The launch of IPOs are an important opportunity for traders to speculate on stock prices in two principal ways. Firstly, IPOs (particularly higher profile ones) almost always come with a certain degree of market interest guaranteed. With more prospective buyers and sellers, that means there’s more opportunities to make a profit (or a loss) for traders.

Secondly, IPOs that are high-profile enough will have what is known as a ‘grey market’ as well. Grey market IPOs are chances for traders to speculate on what they think the IPO share price, and initial market cap, will be at launch before the time of the IPO date. This is another opportunity to potentially make a profit (or a loss) off of an IPO launch as a trader.

That being said, it's vital to note that there are additional risks to speculating on IPOs for traders. IPOs can be very volatile and difficult to predict, as the company has never been public until now and is something of an unknown quantity. A botched trading debut, for example, could result in significant losses for traders.

Also, remember that an IPO company's value and worth is still being determined during the IPO launch stage, which means normal trader due diligence like conducting fundamental analysis and technical analysis isn't really possible.

For this reason, traders of IPOs should not be beginners and should have a decent appetite for risk, as well as a good risk management strategy in place.

The material provided here has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Whilst it is not subject to any prohibition on dealing ahead of the dissemination of investment research we will not seek to take any advantage before providing it to our clients. Pepperstone doesn’t represent that the material provided here is accurate, current or complete, and therefore shouldn’t be relied upon as such. The information, whether from a third party or not, isn’t to be considered as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product or instrument; or to participate in any particular trading strategy. It does not take into account readers’ financial situation or investment objectives. We advise any readers of this content to seek their own advice. Without the approval of Pepperstone, reproduction or redistribution of this information isn’t permitted.