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Three Warning Signs Of Buying IPOs

05/01/12 01:46:26 PM
by Billy Williams

Facebook is the most anticipated initial public offering in recent years, yet IPOs are often losing trades unless you know the three warning signs to protect you from these trades.

Security:   DMD, GRPN, LNKD
Position:   Hold

Recently, the most anticipated initial public offering (IPO) has indicated that it will push its upcoming launch back several weeks, due to all the distractions that the company, Facebook, has encountered, including threats of lawsuits by Yahoo for patent infringement. With no signs of relief, Facebook seems to be a magnet for controversy as well as lawsuits these days.

The IPO will more than likely be launched in late May, close to Memorial Day. This is not an auspicious time for a company to go public, as historical patterns indicate that May is the most bullish month for the stock market but has a tendency to peak and then plummet. With June right on the tail end of a historically volatile month, volume may dry up right as the stock fights to stay afloat.

Despite the possible challenges that Facebook is confronted with, it is one of the most highly anticipated IPOs since Google in August 2004.

FIGURE 1: DMD. Demand Studios, owners of Internet properties like, boasted a greater asset value than the "New York Times," but it did little to boost their stock price after its initial IPO.
Graphic provided by:
And because of this, you need to exercise caution and establish some ground rules in order to not get sucked into the hype and rely on key technical factors if you want to profit and avoid loss.

Be aware that trading IPOs can make you a lot of money, but there are three key factors that you have to keep in mind in order to come out ahead. They are:

1. Don't get sucked into the hype.
2. IPOs rarely go anywhere but down (Figures 1 and 2).
3. Brokers sell, price tells.

FIGURE 2: GRPN. Groupon was another hype-a-thon leading up to its IPO but has only declined since its first day of public trading on the exchange.
Graphic provided by:
First, in the days leading up to an IPO, the big brokerage houses and investment banks will put out a massive public relations campaign that would make Donald Trump blush at the self-aggrandizement and sheer chutzpah that will be gushing forward and talking about how Facebook is different from all publicly traded companies in the history of the market and how they will break the mold and become a new benchmark against which all other companies will be measured, only to be found wanting.

Nonsense. It's hype.

It's hype that is designed to whip you into an emotional frenzy so that you fear missing out on a massive profit as the stock supposedly climbs into the stratosphere. A good rule of thumb is to keep your money close to your chest and wait for the stock to prove itself worthy of a solid investment, not the other way around.

FIGURE 3: LNKD. Linkedin seemed to follow the same downward path as past IPOs, but the stock has clawed its way back to within 80% of its previous retracement, a bullish sign. Linkedin is a good example of an IPO whose price action is proving itself by forming strong technical criteria to make it a worthy long candidate.
Graphic provided by:
Second, most IPOs fall faster than Congress' approval rating and never recover. Yelp, Demand Studios, Groupon, Zynga, Jive Software, and Pandora Media were all darlings in their day as the leadup to their IPOs promised bright futures, only to watch their share prices fall to gut-wrenching lows.

Give IPOs a couple of months to find some price support and from compelling technical factors like trading near their all-time highs and trading in clearly defined trends as price enters a strong phase of expansion, making a steady series of higher highs and higher lows. Then consider an entry.

Finally, remember that brokers will try to sell you on a stock but price will tell you when a stock is worth buying. Some IPOs are definitely worth it, but you have to be patient (Figure 3). If you're ever been smitten with someone but were forced to wait for the right time, that is a good metaphor for trading IPOs. Keep your capital close at hand and wait for things to come into place at the right time before you and your trade come together, but not before.

Keep these things in mind as Facebook's IPO comes up as well as other IPOs and you'll find that by thinking for yourself and being more selective will help you stay on the winning side of the trade and less on the losing one.

Good trading.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

E-mail address:

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