John Lansing

The Right Way to Invest in IPOs

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Trading IPOs is an exciting way to make spectacular gains. It's also a great way to lose money.

Buying an IPO at the offering price, and then selling the stock soon after it starts trading on the open market, is known as "flipping," and it is one of the riskiest ways to invest in IPOs. In fact, it is greatly discouraged by underwriters, especially if done by individual investors.

So I'm going to show you how you should be trading IPOs to maximize your profits and minimize your risk. And with the IPO comeback we're witnessing, now is the perfect time for you to hone this trading strategy.

What to Look for When Investing in IPOs

Before we get to my trading strategy, though, I want to cover a few basics.

IPO stands for initial public offering, and refers to a company issuing its shares to the public for the first time.

Investing in IPOs requires that you do some homework, such as identifying early on which patents, trademarks and key executives can help take a company to new heights.

Think of it this way: If you were transported into the future by pressing "CTRL, ALT, F" on your keyboard, would the products a particular company is selling still be around? The answer to this and similar questions will help you to distinguish between the fly-by-night companies and the ones that are not going away any time soon.

Also, when selecting IPOs to invest in, make sure you take sector performance and industry growth into account.

You Don't Have to be First to the Party … and You Don't Want to be Last

Some of these newbie stocks skyrocket in the hours, days and weeks after they go public.

September's hot issue, Lihua International Inc. (LIWA), which went public on Sept. 4, doubled by the end of that month.

While these kind of quick gains are enticing, and, yes, a lucky few do make spectacular profits, this is a risky game for individual investors. Even if you do get in on a nice run immediately after a company goes public, how do you know when to bail out?

IPOs trade erratically, and because it has no trading history, there's no way to predict what the stock will do next.

LIWA hit its high of $10.69 in early October, and since then shares have given back about half their value. So, if you're not careful, you could end up being the one holding the bag when the party is over.

That's why I prefer to trade the secondary reaction versus the initial "out-of-the-gate" reaction. And that is where technical analysis comes in.

Waiting for the secondary move allows you the benefit of using the charts to guide you through the overall supply and demand picture. By trading the secondary reaction, you avoid whipsaw from buying high out of the gate, and then selling low out of fear.

Using Technicals to Trade IPOs

When trading the secondary move after a stock makes its public debut, I follow these steps:

1. Looking for a Consolidation

After a stock goes public, I watch it for one to three weeks and monitor its volume and trading range.

Volume should begin to decline along with the wild price swings as the stock begins to consolidate. We call that consolidation base building.

In the chart below, I have pointed out a rectangle as an area of consolidation.