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Using Technical Analysis to Trade IPOs

Is it possible to apply technical analysis to trading and IPO? Traders and investors look at the stellar performance with the LinkedIn IPO and think, or hope, that every IPO will behave in the same way. Many other IPOs take-off quickly and then go into terminal decline. It’s not an uncommon feature for an IPO and we need to know if there is a trading solution in this behavior.

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The classic charting methods simply do not apply to IPO trading. There is not enough price history to apply a moving average, or any of the technical indicators that are based on moving averages.

Many fundamental market players place their faith in the IPO launch story and hold on for grim death if the price falls. There has to be a better method. Skilled traders rely on pure chart analysis to identity developing volatility.

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, we 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 to 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 can get it wrong, with some IPOs trading 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, the stock starts in uncharted territory, so there are no reference points for support, resistance, or even trend lines. Indicators that require days or weeks of data, such as moving averages and stochastic cannot be applied.

The trader is left only with the 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) which tracks developing price volatility. 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 downtrend has changed. Closes above or below the line are used to fine tune entry and exit points.

After 3 days we can start to make a decision. Is the stock rising or falling? If it's falling we use the count back line as an entry signal. It's calculated from the lowest low in the trend. 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 1, 2 and 3. The CBL lines calculated from each point are shown as CBL 1, CBL 2, and CBL 3. 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.

Using this technique with IPO an entry is signaled with the close above the count back line at $0.20. 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 signal, or tell the trader 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.

Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders –www.guppytraders.com. He is a regular guest on CNBC's Asia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe.

If you would like Daryl to chart a specific stock, commodity or currency, please write to us at ChartingAsia@cnbc.com.

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