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What Investors Should Know About Price Volatility After An IPO

Initial public offerings (IPO) are usually highly anticipated events for both retail and professional investors. This is especially so if the company that is going to IPO has been gaining much attention even when it was privately owned.

The thing about IPOs is that there are two common price movements associated with them. And, as investors, we should be familiar with them.

The IPO-pop

In some cases, companies that go public can see their stock prices surge high above their IPO price shortly after their trading debuts. This can happen because of enthusiasm from investors who were not able to get in on the IPO because the company’s stock was oversubscribed.

A common reason for the oversubscription is that the company’s IPO underwriters and management underestimated the initial market sentiment and how much investors were willing to pay for the shares.

Earlier this year, a tech company was listed in the US at US$17 per share, only to see its share price appreciate to US$24 within the first day of trading. This is a common phenomenon as companies that are well followed by investors may garner a lot of attention once they go through an IPO. A company’s underwriters and management team may also intentionally keep the IPO price low to reward its initial backers.

The sell-off after the lock up period

There is usually a lock up period after an IPO that prevents insiders from trading the stock immediately after the IPO. The insiders affected are usually early backers of the company, its founders, and managers who own stock.

This lock up period is essential to ensure that insiders do not take advantage of IPOs by immediately selling off their shares once a company goes public. It is also to prevent important shareholders like the founder or CEO from selling their shares, which may cause other shareholders to lose confidence in the company.

However, once this lock up period ends, the affected insiders are free to trade the company’s shares as they please. This can lead to another round of price volatility for the stock as insiders, unbound by the lock up period, start selling their shares to take profits. This is especially true for a company’s early backers – such as venture capitalists – that may have been waiting years to cash out on their investment.

The Foolish bottom line

IPOs can be exciting, especially if we are familiar with the company in question. The enthusiasm and attention that the stock receives immediately after the IPO may sometimes cause wild volatility. As investors, we should not ignore what may cause these short-term fluctuations as we can sometimes make use of volatility to find good buying opportunities for stocks we would like to own for the long term.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't own shares in any companies mentioned.