How to Ride the IPO Wave

The China State Construction Engineering Corp initial public offering was a fast trek to the stars on the first day of its listing last week. The world's largest IPO this year moved into warp drive for 24 hours and then sputtered to a stop.

This is not an uncommon feature for an IPO and we need to know if there is a trading solution in this behavior. The classic charting methods simply do not apply on the final IPO frontier as there is not enough price history to apply a moving average, or any of the technical indicators that are based on moving averages.

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Many market players do have an amazing capacity for believing what they choose -- and excluding that which is painful. Skilled traders rely on pure chart analysis to identity developing volatility.

These methods are used to boldly go where few skilled traders have gone before.

The best guide to a successful IPO is when it closes oversubscribed. Trouble is, by then it is too late to pick up any shares before listing. The danger is that if we try to buy the IPO when it first lists we can end up paying too much. Or worse, get the shares and watch the price steadily decline.

Sometimes oversubscribed IPOs just show us there are more fools in the market than we thought. We want to avoid being a fool so we use trading techniques which help us understand what the market is telling us. If we listen to the newspapers, to the company publicity or the ill-informed crowd of would-be buyers, we often get a wrong impression.

Pricing IPOs is a difficult task. Even the sponsoring brokerage gets it wrong, with some IPOs listing well above, or sometimes, below the subscription price. One of the problems is that the company and the brokerage want to get the best price possible. They choose the best figures and run a publicity campaign. It is difficult to build a true picture of the fundamentals.

From a charting perspective, any IPO is undiscovered country. The tools of technical analysis cannot be used because there is no previous price history. The stock starts in uncharted territory, so there are no reference points for support, resistance, or even trend lines. Indicators that require a day’s or week's of data, such as moving averages and stochastic, cannot be applied.

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The trader is left only with the first contact activity of the market itself once the IPO is listed. This is all we need to make a good trading decision. The decision is based around the count back line(CBL). The CBL is a short term resistance line calculated in a falling trend by counting back two higher highs, and then projecting a horizontal line to the right. A close above this resistance line suggests the down trend has changed. Closes above or below the line are used to fine-tune entry and exit points.

After 4 days, we can start to make a decision. Is the stock rising or falling? If it is falling, we use the count back line as an entry signal. This is calculated from the lowest low in the trend (excluding the first day of listing). We start with the count back line used as an entry signal in a trend reversal. This is a short term resistance level calculated from every new low in a falling trend, shown as A, B and C. When prices close above the most recent CBL resistance level, there is a high probability that the trend has changed direction. The price must close above this line before we can have confidence the new uptrend is developing and sustainable.

This method keeps us out of the trade until at least the fourth day, because we need a minimum of three days of price activity to apply these techniques. The objective is to identify the direction of the trend, and only enter the trade when the trend is up.

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Using this technique with IPO an entry is signaled with the close above the count back line at 6.63. The count back line is based on end of day data, so the signal is given at the end of the day’s trading. The trader takes an entry on the next day of trading. Sometimes we get a better entry price, and sometimes we have to pay a little more. The count back line provides the trigger point for action.

Once the trade is opened, it is useful to manage it with a CBL stop loss until the trend is well enough established to track with other tools, such as a straight edge trend line or moving averages. Until it is possible to apply these tools, the trader’s focus must remain purely on the money management aspects of the trade.

The count back line can be used to set a trailing stop loss and trigger an exit when a trend starts to decline. Taking the most recent highest high in the current up trend, the stop loss point is calculated by counting back three lower bars. The horizontal line drawn at the bottom of the third bar is the trailing stop loss point. The line suggests the conditions where the trend may be weakening. When used with open profits, it provides an exit signal to protect those profits.

Some IPOs give very rapid buy signals, or tell the traders clearly to stand aside from the market. The count back line entry technique is applied as a stand alone trading tool until other technical analysis indicators can be used. These include straight edge trend lines, and after the required number of days, tools, such as moving averages, or indicators, that use moving averages in their calculations. This includes stochastic and MACD analysis.

The count back line technique lets us understand what the market is telling us about the value of the IPO. It allows the trader to establish the direction of the short term trend, and any changes, or reversals. When combined with a stop loss technique, the trader is able to protect trading capital, and later as the trade develops, protect his profits. We use market activity to trade the IPO with a lower level of risk.

While it is true that we miss the action in the first few days, and might surrender some good profit, it is also true that we reduce the risk of jumping on board a sinking IPO. Not all IPOs are tradable. We need to find those that will make us money. This volatility method tells traders if the IPO can cling on to the gains or face defeat. We want to find a strong uptrend that will live so we can prosper. Unless the IPO gives a clear buy signal, it may be a good idea to stay out of the market and wait for more definite opportunities.

If you would like Daryl to chart a specific stock, commodity or currency, please write to us at ChartingAsia@cnbc.com. We welcome all questions, comments and requests.

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