When it comes to investing in IPO stocks, new issues don't play by the usual rules.
XCompanies making initial public offerings draw a lot of investor attention. That often results in unusual and brand-new chart patterns. Volatility can rise as investors size up demand for the new stock. Yet there are opportunities in these cases, if you can spot the correct characteristics amid the price-and-volume action.
The framework of a good IPO base is simple. The decline from peak to low usually doesn't top 20%, but the most volatile markets have produced declines of up to 50%. The length is often less than five weeks and can be as short as seven days. These two factors alone make IPO bases wayward cousins compared with proper bases, such as the cup with handle and flat base, which need at least five to seven weeks of work.
In an IPO base, the pattern typically starts within 25 days of the stock's first day of trading. Know the important similarities with regular bases. For example, the buy point is drawn by taking the prior high and adding 10 cents. The price gain on the breakout should be strong.
Investors studying IPO bases are partly blinded because new issues don't have enough trading history to generate tools like the Relative Price Strength Rating or the Accumulation/Distribution Rating, as compiled in IBD's proprietary research tool, Stock Checkup. Volume comparisons are difficult, too.
There are ways to evaluate these blind spots, however. Important factors include seeing a shallow correction within the base during normal market conditions, a large increase in price and a close near session highs on the breakout day, and heavy volume on the breakout day and week.
Also, the stock should generally form the base above its IPO price.
An Outstanding IPO Base And The Breakout
ServiceNow (NOW), the business software company, went public June 29, 2012, at 18 a share, and met with immediate success as the stock leaped to a close at 24.60 as nearly 11 million shares exchanged hands.
The temptation is to buy the stock right then and there, with all the euphoria working its way into more gains. But that's a key point to understand about IPOs: It's best to pass on the first heated days of trading and wait for the base to emerge.
ServiceNow started basing a few days after its debut (1). It declined a moderate 14% to its low and after consolidating for 17 days, it made a new high in a July 31 breakout (2). Volume wasn't impressive but it grew sharply above the levels in the prior four sessions (3).
Shares became volatile, but held above the 10-day moving average. After the breakout, ServiceNow gained 58% in less than three months before peaking at 41.77.
IPO Stocks Can Form Multiple Bases
The stock didn't create its first regular base until October 2012 to April 2013, when ServiceNow fell from a 41.77 peak to a low of 25.54, a 39% correction. Investors waiting for the eventual buy point from that base would have missed out on a superb run.
