IPO Investing And Lockups: Here's What Investors Should Know

As ride-sharing company and recent initial public offering (IPO) Uber Technologies Inc. UBER approached the lifting of its “lockup” period early this month, shareholders received an unwelcome splash of cold water when the stock crumbled 17% over just a few days. 

“Some of the UBER losses are attributable to its Q3 earnings report on Nov. 4, but the lockup expiration certainly played a role in the sell-off,” said Dennis Hobein, senior analyst at research firm Briefing.com. 

Does this mean investors should stay away from IPOs until the lockup ends? Not necessarily. Though it’s definitely something to keep in mind, the lockup isn’t an automatic reason not to invest, either. Here’s what to know about lockups, how they affect stocks, and possible ways to navigate them as an investor.

What’s A Lockup?

Many companies compensate their teams with large stock awards, but they don’t want employees to sell large amounts of stock as soon as the company starts trading so they use “lockup” periods—which typically last 90 to 180 days and prevent employees and other insiders from selling their stock when the company goes public. The stock can be much more volatile depending on lockup restrictions, and those aren’t always set in stone, either.

“Lockup periods are important for investors to monitor because the supply of stock available in the public market (known as the float) can increase significantly once insiders begin selling,” Hobein said. “Unless an accompanying increase in demand meets this new supply, the stock price is likely to fall, at least in the near-term.”

Keep in mind, however, that a stock typically will react to the lockup period ahead of time. In other words, shares will often decline a few days or more prior to the expiration date as investors look to exit the stock before the new supply hits. That’s what might have happened with UBER (see figure 1 below).

Another recent example of lockup-related drag was Beyond Meat (BYND), whose shares are down more than 40% over the last month even though the company reported better-than-expected earnings and outlook. Some analysts said shares came under pressure because holders had started to worry about a possible burst of selling when the lockup ended Oct. 29. In this case and others, the mere fact that a lockup is out there, like a troll under a bridge, can be enough to spook investors.

Not all lockups work the same, either, which can cause more confusion. Fitbit (FIT), for instance, lifted lockup restrictions on 2 million shares early and announced an offering of 21 million additional shares not long after its IPO in 2015. The stock fell 10% in after-hours trading. It wasn’t a traditional lockup, in part because people didn’t expect the company to ask for an early lifting of some restrictions. You never know if the nifty IPO you’ve parked your money in might do something similar.

Another thing to keep in mind is that sometimes there are multiple lockup periods for a single IPO. This is done so that the market isn’t flooded with a huge new supply of stock in a single trading session. Usually, multiple lockup periods are used for larger IPOs with a substantial amount of shares owned by executives.

Know what you’re getting into. Just because you think the lockup period is over doesn’t mean there isn’t another one waiting to potentially bite you later. Consider curling up with the company’s IPO prospectus before investing so you’re less likely to be surprised later.

IPO Investing Drawbacks

That brings us to a key point. Before discussing ways to consider dealing with the lockup as an IPO investor, let’s note that IPOs, by definition, are packed with risk and might not be for everyone. Even for IPOs that have early success, the lockup period is a risk that most investors have to face when they dive into a newly-public company. That might have been a hard lesson for some BYND BYND investors.

Before jumping into an IPO, consider learning some basics to help you avoid getting burned by a new offering. IPOs were once available mainly to institutional investors, but today many retail investors have the same opportunities to invest in newly public companies.

A lot of people, especially young investors, make the mistake of associating a product with the stock and park their money in newly public firms. Those who did this year might have gotten burned more than once as the market chewed up IPOs of UBER and Lyft Inc LYFT, while BYND was a summer darling that gave ground in autumn.

“When it comes to IPOs, investors should consider keeping a cautious outlook,” said JJ Kinahan, chief market strategist at TD Ameritrade. “Many times in recent years, an IPO with a lot of publicity and hype sold off soon after its opening day.”

IPO Investors: Consider These 4 Lockup Strategies

For those willing to venture gingerly into this volatile area of the market, however, there are potential ways to deal with the lockup. That doesn’t mean you can expect success, because nothing in the market is guaranteed. Still, here are some ideas that might help you navigate through the lockup period of your favorite new company.

First, know your options. Literally. 

For instance, if you really loved BYND or UBER as a company and wanted to get into the stock early after the IPO, it might have been a risky idea to throw caution to the wind and simply buy shares. That would have left you unprotected if the stock crumbled approaching lockup. One alternative, with risks of its own, is to use the options market to try to help protect your investment.

Strategy #1: Long Put Options

One idea is to buy a protective put option. Long put options aren’t just for bearish traders. Buying puts can also be valuable if you’re bullish but wish to be cautious and look for a measure of short-term protection against an unforeseen drop in price—which, as we know, can happen around a lockup expiration.

Strategy #2: Option Collar

A potential idea if you’re interested in an IPO but know the lockup period is coming is to consider an options strategy known as a “collar.” Besides the stock you’re looking to protect, a collar consists of two options from the same expiration period: a long out of the money (OTM) put and a short OTM call. The idea behind the collar, rather than the long put by itself, is to allow the premium collected by selling the call to help pay for the cost of the put option.  

Just as the put limits your risk should the stock price drop below your put strike, the short call caps your potential profit on the stock. Think of the put as a “floor” beneath your stock, and the call as a “ceiling.” Your choice of where you put the floor and ceiling determines the overall risk/return of your position. 

Strategy #3: Stop Order (aka “Stop-Loss” Order)

Here’s another potential strategy if you’re very confident that demand will be strong for an IPO and think the stock is likely to move higher over its first few trading days: You can buy the stock once it trades in the public markets and set a protective stop order to limit downside risk. A stop order is one that would sell the stock position if it drops to a certain price. It’s important to note that entering a stop-loss order does not guarantee execution at or near the price. Once activated, the order competes with other incoming market orders.

“Knowing that a large lockup expiration looms, you’d then (hopefully) lock in profits after a few trading sessions and revisit the name after the lockup period expiration,” Hobein said. “Of course, it doesn’t always work out that cleanly and conditions would need to be favorable in the stock market for this strategy to be reasonably viable.”

Hobein called this a “more aggressive” IPO trading strategy. For those with less risk tolerance but who still want a bite at the IPO market, he said, patience could be a virtue.

Strategy # 4: Watch, Wait, and Move in Increments

Consider this: Find out how many shares will be unlocked at expiration. Not all lockup periods are equal. In fact, many times, the lockup period has a fairly limited impact on the stock because the number of shares being freed up isn’t too substantial. Investors can find out how many shares will be involved in the lock up period by checking out the IPO prospectus.

“In the case of UBER, in which 1.7 billion shares were made available for sale, I believe many investors simply wait for the lockup period to expire before buying shares,” Hobein said. “Once the dust settles, the stock typically stabilizes.”

For instance, he added, this might have been the case with UBER. After tanking by 17% in the week ahead of its lockup expiration, UBER has moved higher by about 5% over the past few days.

Another possible way to try and protect yourself with an IPO investment either before or after lockup is to consider buying shares in partial increments rather than going all in at once. 

“People can be excited to invest in these companies, but it’s good to keep the potential downside in mind,” Kinahan said.

Information from TDA is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade.

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