Stay Out of the IPO Market Until it Flashes This “Buy” Signal

To most people, the shares of recent IPOs – new companies that become publicly traded for the first time – look red hot…

#-ad_banner-#Yesterday the market’s latest IPO, Pandora Media (NYSE: P) rallied double digits. Back in May, LinkedIn’s IPO (NYSE: LNKD) rallied 47% in its first day of trading.

Again, to most people, double-digit gains in a day seem pretty impressive.

But I recommend you stay out of the IPO market… until it flashes the “buy signal” that I’ll show you in this alert. I’ll show you the buy signal in a moment.

But first, here’s why I recommend you stay out…

Despite the red hot start, if you bought shares of LinkedIn the day it started trading, you could be down more than 38% on the year – shares have been moving lower steadily since.

Likewise, if you bought Pandora at the height of Wednesday’s trading, you could be sitting on losses of 30%. Here’s another chart:

So much for buying a “hot IPO,” eh?

You see, the current slew of IPOs (and yes, there are many more in the pipeline) is predicated on hype and promise, not cold hard numbers. While that may fly in a more buoyant market, it’s a toxic situation given the weakness stocks have seen since the beginning of June. It’s something that I wrote about following LinkedIn’s IPO – hopefully you weren’t suckered into the new, hyped names that have started trading since.

All of that said, there is a way to profit in spite of weakness in the IPO market…

In fact, as I see it, the key is finding technically relevant levels on newly-public names. Let me show you a real-world example:

Trading IPO Names For Fun and Profit

Back in late 2010, Tesla Motors (NASDAQ: TSLA) was a lot like LNKD. Shares had gone public in late June of last year, only to peak on their first trading week and move lower over the next few months. But on October 20, 2011, my Penny Stock Fortunes colleague Greg Guenthner and I recommended buying shares – since then the position has rallied more than 40%.

So, what was the key to cashing in IPO gains on Tesla?

The first factor was quality. Even though Tesla’s fundamentals were nascent, the stock was offering a muted valuation relative to its potential. Still, investor exuberance can overpower a stock’s “story” any day of the week – to get the timing right, the stock still had to be a technically relevant buy. Take a look at its chart:

Even though shares of Tesla had only been public for a few months, the company’s chart told us a wealth about how the market was pricing this stock. After peaking, shares sold off to the $15 level, setting ultimate support. After that, shares carved out two more significant support levels (the thick white and red horizontal lines in the chart above) that offered us a good buying target and stop loss target respectively.

Simply put, support can be thought of as a “price floor” for shares of a stock. They’re levels where shares have found an intermediate bottom – that low point indicates that there’s a glut of demand for shares at that price.

In practical terms, a support level is the price where investors start to think, “Hey… that stock looks cheap!”

Support levels are often the lowest price a stock trades at (at least for a while) not surprisingly, then, investors want to buy shares close to support.

In short, a bounce off of support lines is the “buy signal” you should wait for when looking at these IPOs.

Even though buying Tesla was a long-term position, the factor that made this trade successful was the fact that we picked up shares when probabilities highly favored the demand side of the equation. That’s exactly the scenario that you should be shooting for on any IPO trade regardless of your time horizon.

From a technical analysis standpoint, LinkedIn is starting to look like Tesla did – but it’s still too soon to tell whether it will make a good buy. Shares still have yet to set a meaningful support level.

My recommendation: give the latest batch of IPOs a few months… wait for the “buy signal” to flash… and then look for a chance to buy just above support.