An old friend excitedly texted me over the weekend.
He wanted to get my thoughts on Spotify and Dropbox, two hot initial public offerings set to hit the market sometime in the next few weeks.
“I don’t trade IPOs,” I replied.
While my buddy was disappointed that I didn’t have any hot tips for him, we ended up having a productive conversation about how new stocks trade -- and the best time to buy them.
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First of all, I think Dropbox and Spotify are good companies. But before blindly jumping onboard a brand-new stock, there are a few key factors you (and my stock-watching friend) should consider.
If you’re going after new stocks, you need to know how to trade the IPO sweet spot. This strategy is the only way to safely play for the big rips higher while avoiding catastrophic losses.
You see, IPOs are one of the trickier trades on the market. It’s tempting to take a huge hack at them right when they begin trading, especially when you’re dealing with a hot name.
Sometimes it pays off, and other times you might get burned.
GoPro Inc. (Nasdaq: GPRO) is the perfect example.
Traders enjoyed a couple of opportunities for a swing trade when GoPro shares first hit the market in 2014. GPRO breaking out of its range in early September 2014 was the most “tradable” move. But like many IPOs, anyone looking to hold longer than a few days or weeks had to contend with a massive flameout after the September rally.
After topping out, GPRO gave up a majority of its initial gains and fell right back into its trading range.
Even if you timed the trade perfectly and bought as soon as shares went public, you would have given up most of your early gains had you held onto the stock through that first harrowing drop.
Unless you’re willing and able to trade in and out of an IPO, buying one before it even gets a couple of moving averages under its belt probably isn’t the best idea. Since our trading timeframe looks ahead more than just a few days, we want to wait for an IPO sweet spot instead.
Here are two ways I like to play IPOs, complete with real world examples:
The first setup is the coil that emerges when the IPO doesn’t race higher right out of the gate. Facebook (Nasdaq: FB) is a great example of how this strategy worked for patient traders and investors. The stock looked like a dud when it went public back in 2012. Once it failed at its highs on its first trading day, everyone complained the offering was overhyped and overpriced.
It took more than a year for Facebook to find its footing. But a picture-perfect sweet spot offered an ideal entry for anyone paying attention. The stock’s trading range compressed like a coiled spring and finally exploded higher in 2013.
Once Facebook shares broke out, they never looked back.
Then there’s the boom and bust setup.
In this situation, you want to wait for the run-up and subsequent crash before establishing a position in a new stock. This sweet spot can take a little while to materialize — but a little patience goes a long way.
Check out Snap Inc. (NYSE: SNAP). After its IPO pop, the stock trended lower for almost a full year before setting up for a breakout move. Snap is a stock that had to give back all its gains (and then some) before flashing a clear long-term buying opportunity:
Snap shares were cut in half after it hit the market in early 2017. We didn’t see the bottoming process begin until the fall. Instead of a coil, Snap shares flattened out, forming an eight-month rounding bottom before breaking out last month.
For longer-term IPO trades that won’t shake you out of your position or leave you with crippling losses, it’s all about waiting for the sweet spot.
No, you won’t be in the stock from its very first day as a public company. But you will save yourself a lot of pain and suffering while the stock finally finds its legs.
This article originally appeared on The Daily Reckoning.