How does an IPO work and how do you trade in them?

IPO stands for Initial Public Offering. IPOs are an important aspect of the trading world and play a significant role in the growth and expansion of companies. Note IPO presents a prime opportunity to own shares in a public company and potentially profit from price movements.

However, the process of trading IPOs slightly differs from trading regular stocks. So it’s important to understand the nuances associated with trading these securities.

So how does an IPO work? What does a company going public mean? And how do you go about trading IPOs?

This guide aims to provide a comprehensive understanding of an IPO — what it is, why it’s important, how it works, and what factors to consider when trading them.

How does an IPO work?

So what does it mean for a company to go public?

Simply put, a traditional IPO is the process through which a private company transitions into a publicly traded entity. It represents the first time that a company offers shares of its stock for sale to the general public.

An IPO filing marks a significant milestone in a company's growth trajectory. It enables the company to raise capital, increase its visibility, and expand its business operations.

If you need an example of an IPO, Google, Amazon, Apple, Microsoft, Facebook, and several other companies whose stocks are listed on global stock exchanges all went through an IPO process. Look how far they’ve come since then.

To a trader, an IPO is a great opportunity to own a part of the company early on. If the price of the company’s stock goes up, you make a profit; if it goes down, you make a loss.

That’s the basic gist of it, though there are a number of important considerations for various parts of the IPO, which we’ll cover later in the article.

What an IPO involves

The IPO process can be complex and time-consuming. Let’s break it down into key stages, so you have a better idea of what’s involved.

Preparing for an IPO

This is when a private company evaluates its readiness to transition to public ownership.

There are certain thresholds that a company must meet before it can file for an IPO. For one, it must be financially stable with a track record of consistent revenue growth and have a clear path to profitability.

The company must also demonstrate its willingness to adhere to regulatory compliance and good corporate governance practices.

Selecting underwriters

Here, the company must do due diligence by engaging the services of an IPO investment banking team or underwriter to manage the IPO process.

This institution will help the company determine the IPO price, structure the offering, and market the shares to potential shareholders.

They also assist with the regulatory requirements and liaise with an authority, for example, the Financial Conduct Authority (FCA) in the United Kingdom.

FCA registration and filing

This registration includes information about the company's financial performance, management team, risk factors, and business plan. The FCA then thoroughly reviews the registration statement to ensure compliance with regulatory standards.

The roadshow

This is when the company, alongside its underwriter(s), meets with potential shareholders to discuss the plan to go public and answer questions. The goal here is to generate interest in the IPO and get traders to commit to the project by subscribing to the IPO for IPO financing.

Pricing and allocation

This deals with determining the IPO stock price and takes place before the company's stock launch. The price is set by an investment bank after consulting with the company management.

The offering price is also influenced by factors such as market demand, trading demand, and the company's current valuation.

Going public

This is the day the company's shares are listed on a stock exchange to raise money. Traders can now officially begin buying and selling these shares.

Like any other instrument traded in the financial markets, the price of the shares can fluctuate based on market demand and supply.

How to trade in an IPO situation

Participating in the debut of a newly listed company is often an exciting experience. But that excitement must come from a place of confidence in your knowledge about the stock, rather than from a place of naive hope and unrealistic expectations.

That said, there are three basic ways to trade IPOs — the IPO subscription process, secondary market trading, and IPO CFDs.

IPO subscription process

This is the initial phase of IPO trading, which happens when a company goes public. If you expressed your interest in purchasing shares of the newly listed company during the roadshow stage or in the offering period leading up to the IPO date, then you get your shares.

If you bought your shares before the official IPO date, you will be subject to the lock-up period, which usually lasts 90 to 180 days after the IPO. During this period, shareholders are restricted from selling the stock.

This is strictly a buying process — there’s no selling involved since the shares are coming to you directly from the company.

Sometimes you might not get the full amount of shares for which you subscribed. This usually happens when there simply aren't enough shares to go around. We call this situation an IPO oversubscription.

In this instance, the underwriters will allocate the available shares based on factors like the overall demand for the stock, subscription amount, time of subscription, and more.

Secondary market trading

So how does an IPO work for existing shareholders?

After the completion of the IPO subscription process, an individual investor can now decide on the number of shares to sell on the stock market. Interested traders who missed out on the IPO subscription can buy these shares.

In the secondary market, the share price of the company is determined by the supply and demand of the stock.

If private investors are rushing to buy it, then the price shoots up due to high demand and low supply. The reverse is the case if there is low demand and high supply.

Trading IPO CFDs

IPO Contracts for Difference (CFDs) are financial instruments that allow traders to speculate on the price movements of newly listed companies without owning the underlying shares.

An IPO CFD mirrors the price movements of shares of a company during its initial public offering. These derivative contracts are popular among traders due to their flexibility, leverage, and ability to profit from both rising and falling markets.

Although leverage allows you to buy a position with less money from your pocket, it is a double-edged sword that can result in huge gains, as well as substantial losses. Hence, it is best to proceed with caution.

Trading IPO CFDs means taking a position on whether you believe the IPO share price will rise or fall. If you anticipate a price increase, you enter a "Buy" or "Long" IPO position. On the flip side, if you expect the price to decrease, then you enter a "Sell" or "Short" position.

If the IPO share price moves in the direction that you anticipated, then you profit from the price difference when you close the position. However, if the price moves against your prediction, then you incur a loss.

That’s why it’s important to know how to understand the risks involved and have a solid trading plan in place before engaging in IPO CFD trading.

Shorting an IPO

You can short an IPO as soon as the IPO lock-up period ends. The lock-up period prevents too many shares from flooding the market within a short time frame.

Read Also: What is shorting in trading? (A comprehensive guide with examples, pros, and cons)

What are some important considerations for IPO trading?

• Research: Do your research about the company and make sure that buying or selling IPO stocks aligns with your long-term trading goals.
• Risk assessment: IPO trading can be risky given the limited historical data, the possibility of leverage, and uncertainties surrounding the company's future performance. There’s also market volatility to consider. So evaluate your risk tolerance and trade accordingly to your risk appetite.
• Access to Information: Stay informed about the company's IPO details, financial performance, and any market news that may impact the share price. Conduct thorough research and analysis before trading IPO CFDs.
• Market sentiment: The general sentiment about an IPO stock can have a significant impact on how well it performs in the market. Monitor market news, expert opinions, and trader sentiment to gauge market dynamics.
• Trading tools: Prioritise the right trading tools. In an IPO, as it is the first time the company stock is being traded, there isn't enough data to perform technical analysis. As such, you’re better off evaluating the company’s fundamentals to gain insight into how the stock may perform in the weeks and months to come.

Key takeaways

• An IPO is the process through which a privately held company offers its shares to the public for the first time.
• Companies must meet requirements by exchanges and the FCA to hold an IPO.
• IPOs provide companies with an opportunity to obtain capital by offering shares to the public.
• Companies hire underwriters to manage the IPO process.
• IPO trading involves two main phases: the IPO subscription process and secondary market trading.
• During the IPO subscription process, you can express your interest in purchasing shares before they become available for trading on the secondary market.
• You can also choose to trade IPO CFDs, which involve leverage and considerable risk. Choosing a reliable broker platform is key.
• You can manage your IPO trading risks through risk assessment, a sound trading strategy, observing market sentiment, and using analytical tools.

Risk warning: CFD trading involves risk and may not be suitable for everyone. Ensure you fully understand the risks involved and seek independent advice if necessary. This blog post was written for educational purposes only and should not be considered financial advice.