The IPO market can be a wild place. While it’s not uncommon for an offering to spike over 50% on the first day of trading, there have also been plenty of duds. Just look at companies like Groupon (NASDAQ:GRPN), Zynga (NASDAQ:ZNGA) and Facebook (NASDAQ:FB).
Even with the disappointing offers, though, some investors still have made a lot of money. How?
By shorting them.
Sure, this investment technique seems bit strange (and maybe even anti-American, if you want to go a step further). But many of the world’s top investors, like George Soros, short stocks.
Here’s how the process works, in an nutshell. Let’s say you think Zynga will plunge. You you borrow 100 shares at $10 a piece, which comes to $1,000. This amount is held into an escrow account. You will not get access to the money until you buy back 100 shares and return them to the brokerage you borrowed them from. Thus, if Zynga falls to $2, you will have made an $800 profit.
When doing this with a brokerage account, the process is just a matter of pressing a few buttons.
However, there are some quirks when shorting IPOs. One is that it can be extremely tough to borrow the stock within the first month or so of the debut, because the brokerages need time to get access to the shares.
Another problem is that an IPO generally has a small initial float, or a limited number of shares in the market. The reality of heavy demand and low supply is also why deals tend to surge.
For a short seller, there is thus a big risk of getting a short squeeze — when a stock skyrockets and short sellers try to cover their positions, which creates even more demand. It can be brutal.
With that said, it’s probably best — as a general rule — to avoid shorting an IPO until the lock-up period expires. That’s often six months or so after the offering. After that, insiders are allowed to sell much larger amounts of their shares. In fact, the stock price often starts to fall a week or so before the lock-up expires as investors anticipate a deluge of shares to hit the market.
Of course, there are always exceptions. One case where it may make sense to take a short position for an IPO is when a company misses expectations on its first quarterly report. This is a very bad sign, as it shows that the company does not have much visibility in its business and may indicate that the growth story has peaked.
In fact, such was Groupon’s fate. The company missed earnings expectations on its 2011 fourth-quarter results and the stock dropped over 10% to under $22. Since then, the growth continued to deteriorate and by November, the shares were trading below $3.
The bottom line is pretty simple: Shorting IPOs can be profitable, but investors need to be careful. Because of the volatility, there are certainly opportunities for taking on big losses.
And if you’re going to try the strategy, you should only have a small portion of your portfolio in short positions — probably no more than 5% or so. Extend beyond that, and your losses can certainly add up — even with just a couple bad bets.
Tom Taulli runs the InvestorPlace blog IPO Playbook. He is also the author of “How to Create the Next Facebook” and “High-Profit IPO Strategies: Finding Breakout IPOs for Investors and Traders.” Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.