Why IPOs Can Be a Trap for New Investors

New traders often ask me if they should get involved with Initial Public Offerings (IPOs). The short answer is tricky: for someone who knows the ropes, IPOs can be incredibly profitable. But for those who don't, they're often a quick way to lose money. Let's break down why.

An IPO is when a private company opens its doors to public investors. This happens in one of two ways: insiders like founders and venture capitalists sell their personal shares, or the company issues brand-new shares to raise capital. Once these shares are created, they get listed on an exchange like the NYSE or Nasdaq, where anyone can trade them. This process lets early investors cash out and gives the company a fresh injection of cash for growth. For those exploring different forms of , this can seem like an exciting opportunity.

The Insiders' Advantage

Big IPOs for companies like Facebook, Uber, or Lyft always generate a ton of media hype, which helps attract buyers. The problem is that an IPO often becomes a massive wealth transfer from regular retail investors—the “dumb money”—to the insiders and institutions, or the “smart money.” When you're in an IPO, you have to remember who you're buying from. These are insiders who know the company inside and out, from its biggest strengths to its fatal flaws.

They might be selling because they believe the company's best days are behind it, or they could simply be cashing out to buy a private jet. Either way, they have perfect information, and you have close to none. You’ll often see a flood of IPOs near the end of a long bull market, just like we saw in 1999 and again in 2019, as insiders rush to sell at peak valuations.

Why IPO Stocks Are So Volatile

For an experienced trader, IPOs can be fantastic vehicles. The reason comes down to two things: a small “float” and strong institutional support, at least for the first six months. A small float means that only a tiny fraction of the company's total shares are available for public trading. The rest are “locked up” and can’t be sold for a set period, typically around six months.

With so few shares in circulation, it doesn’t take much buying or selling pressure to move the price dramatically. Look at Lyft (LYFT). It issued just 32.5 million shares out of 273 million total—a float of only 12%. When short-sellers targeted the stock, it plummeted from over $88 to the high $40s in no time.

The reverse is also true. PagerDuty (PD) also had a float of just 12% and shot up from the high $30s to over $50 shortly after its debut. We’ve seen this pattern before with companies like GoPro, which ran from $30 to nearly $100 before crashing, and Twitter, which jumped from $45 to $73 before falling back down. This is a core concept for anyone to grasp.

Two Ways to Approach IPOs

There are really only two ways to think about an IPO: as a long-term investor or as a short-term trader.

The Long-Term Play

If you see for long-term wealth, this might appeal to you. Had you bought a single share of Coca-Cola for $40 at its IPO in 1919 and reinvested the dividends, you’d have over $15 million today. The same goes for early investors in Walmart, Disney, or Microsoft. Of course, there's a flip side. If you bought Webvan, an online grocer that IPO'd in 1999, your investment would be worth zero today.

The challenge is that most companies don’t become the next Microsoft. To succeed as a long-term IPO investor, you need deep industry knowledge and the stomach to hold on through brutal downturns. Even Coca-Cola stock dropped 50% in its first year.

A bigger issue today is that companies are staying private for much longer. Amazon went public just three years after its founding with a valuation of $438 million. Uber waited ten years and went public with an $80 billion valuation. The massive early growth now happens in private markets, leaving far less on the table for public investors.

The Trader's Game

The second approach is to treat IPOs as short-term trading vehicles, taking advantage of their volatility. In my experience, the more hyped an IPO is, the better it is as a potential short if the price action turns sour. For buying, I prefer to focus on more obscure companies.

My strategy for in IPOs involves a few steps:

1. I’ll watch a new IPO for a couple of weeks to get a feel for its trading behavior.
2. If I think the S&P 500 is headed down, I’ll look to short a recent IPO with a small float. These stocks can fall 50-75% when the broader market only drops 10%. Conversely, if the market is bottoming, I’ll buy a recent IPO, as it could rally 100% or more on a 10% market bounce.
3. I look for recent IPOs trading in a tight range on declining volume. When the stock breaks out of that range on high volume, I’ll often buy in and hold for a few weeks with a trailing stop.

Discipline is non-negotiable. Always use a stop loss. Too many people buy an IPO as a trade, ignore their stop, and end up holding a losing “investment” all the way to zero.

Don't Forget the Lockup Expiration

Finally, always be aware of the IPO lockup period. For the first 180 days, insiders are typically barred from selling their shares. When this period expires, they are free to sell, which can flood the market with new supply and send the stock price tumbling. Pay close attention to how a stock behaves around its lockup expiration date; it can be a major catalyst for a big move.