The Three IPO Investing Rules to Follow for Any New Stock

ipo investingIPO investing can seem like an exciting way to reap huge profits. But the truth is, all of the excitement can blind investors from the losses that loom down the road.

Take the Etsy Inc. (Nasdaq: ETSY) IPO, for example. The online marketplace went public on April 16, pricing at the high end of its $14 to $16 range and raising $267 million. It gained 87.5% in its first day and was one of the most successful tech IPOs of the year.

Since then, ETSY stock has plummeted 53.2%. It's currently the worst IPO of 2015.

As alluring as the deal was, it only benefited institutional investors willing to buy large quantities of ETSY stock before its debut. These Wall Street "VIPs" usually see immediate profits while retail investors are forced to purchase shares at an inflated price.

In other words, IPO investing is a recipe for hefty losses for traders like you and me.

"The IPO process is now a rigged game - one in which the founders, the early angel investors, venture capitalists, and the investment bankers all make out like bandits," explained Money Morning Chief Investment Strategist Keith Fitz-Gerald. "They don't give a rat's you-know-what about whether you make money."

Despite the unfair IPO investing process, there are still a few ways to profitably play a hot stock debut.

Here are the three best ways to score big gains from new IPOs...

The Three Best IPO Investing Rules to Follow

IPO Investing Rule No. 1: Hold off until the lock-up period is over.

It's always best to wait until the frenzy settles down and the IPO lock-up period has ended. The IPO lock-up period is the stretch of time after a company goes public in which insiders like founders and venture capitalists can't sell their shares of the stock. It can last anywhere from 90 to 180 days after the company hits the market.

Letting the dust settle gives you time to consider the stock's profitability and ensures you get the best return on your investment. You'll also avoid much of the early volatility new stocks experience.

Here are two more important IPO investing rules to follow...

IPO Investing Rule No. 2: Make the company prove it merits your money.

Three Best IPO Investing Tactics

  1. Wait until the IPO lock-up period has ended. This usually lasts 90 to 180 days after the IPO. There's usually a flood of sell-offs after the lock-up is over because institutional investors want to sell their in-demand shares to retail investors and get rich quick. You'll want to hold off even longer than the end of the lock-up, which leads to the second rule...
  2. Let the company prove it's worth your investment. It can only do that over the course of a few quarters. You'll want to check out their earnings reports and see if their top-line and bottom-line numbers are growing. These include revenue and net profits.
  3. Use lowball orders when purchasing the stock. Lowball orders are used to buy a stock for significantly less than its fair value. They let you safely set your own price and prevent you from paying too much for a risky trade.

Before buying a new stock, you'll also want to wait for a few quarterly earnings reports to come out.

One reason Etsy has fallen so far from grace is the company's disastrous first-ever earnings report. It reported a net loss of $36.6 million in Q1, compared to a loss of $500,000 in Q1 2014. Shares responded by falling more than 19%. The numbers reflected how far away Etsy is from becoming profitable.

You never want to invest in a company that isn't profitable. The only way to figure that out is to wait for the firm to release its financials.

"IPO hype is based on what 'could be,' not what 'is,'" Fitz-Gerald said. "Many times management cannot make the jump, and you do not want to pay the price for finding out which is which."

IPO Investing Rule No. 3: Use lowball orders.

A lowball order is an order that's significantly below the fair value of a stock. It is commonly used to gauge the seller's expectations for the value of the asset.

Lowball orders are perfect for new stocks because they give you the power to name the price. It's always safer and more profitable to set the price you want and have the market come to you.

They also prevent you from chasing a risky trade, which can be tempting when a hot IPO hits the market.

"Temptation is the most powerful of all emotions, which is why Wall Street hypes IPOs the way they do," said Fitz-Gerald.

The Bottom Line: IPO investing can seem like a thrilling enterprise. Today's IPO culture displays the illusion that immediately investing in brand-new stocks can make you rich quick. For retail investors, that couldn't be further from the truth. The best ways to profit from IPOs are to wait for the lock-up period to end, gauge a company's profitability over a few quarters, and set your own price.

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More on IPOs: The IPO roadshow - sometimes referred to as a "dog and pony show" - is the most important step a company takes to market its IPO. So important, in fact, that 82% of institutional investors worldwide cite it as a key component in their buying decisions. Here's a detailed breakdown of what happens during the roadshow process...