Risk Happens Fast

"Risk happens fast." This is a phrase I learned in trading and investing quite some time ago, and it holds true. Accidents don’t unfold slowly. The story generally goes like this: One moment everything is fine, and in an instant, everything changes. A risk presents itself with immediate ramifications. It's fascinating that even known risks can manifest rapidly when they do appear.

In popular culture, people often discuss the housing bubble of the early 2000s and the resulting financial collapse of 2008 as if no one saw it coming. That’s simply not true—warnings were issued for years. But when the crisis hit, it hit fast.

However, there's another kind of risk—the risk we fail to take, which leads to missed opportunities. On a smaller scale, this phenomenon of “fast risk” applies to trading in IPO stocks in both respects. Having acutely focused on new issues for many years now, I have seen both situations arise countless times. A company goes through the underwriting process, issues their stock to new investors, and opens at a premium of, say, 50%, only to trade to eye-popping heights from there. I have also seen the reverse happen, where a company issues shares, opens with the same 50% premium, and then immediately crashes lower in the first hours or even minutes of trading. Risk happens fast.

Adding to the complexity of these situations is that traditional approaches to informing decisions, such as relative valuation or technical analysis, leave much to be desired. Often, new issues that subsequently perform well open at valuations much higher than their peers. Technical analysis requires some price and volume history to apply this methodology, so while calamities may be avoided by waiting for information, opportunities are also missed.

In an effort to inform our decisions at IPO Prophet using alternative methods, we analyze the first day of new issue trading as events. By doing so, we find differences in price behavior. The following charts illustrate how both types of risk do indeed happen fast. The first minutes of trading are markedly different for extreme winners and extreme losers in comparison to the price behavior of typical new issues.

Both charts analyze the percentage change in price on a one-minute basis relative to the open price. The groups of stocks are broken into a sample of outliers versus the rest of the securities in our database. We compute the average percent change at each minute with their accompanying standard deviations. The shaded areas represent plus or minus one standard deviation from the respective means. The idea is that the further an individual stock moves in price away from the sample group, the more likely it is that the stock is indeed on a vastly different trajectory. This group of outliers is constructed of new issues that had the greatest positive or negative change in price relative to the open price. So in this analysis we are analyzing the rate at which the price is changing.

The first chart analyzes our first scenario, where we are looking at securities that have opened and quickly ascended in price.

Key Observations:

• Initial Increase: The study group (blue line) exhibits a sharp increase from the opening price, indicating a significant rise in stock prices right at the beginning of the trading day. In contrast, the larger group of All Securities (purple line) shows a much more stable and less volatile performance, staying close to the zero line with minimal change.
• Rates of Increase: The study group increases rapidly in the initial minutes, reaching a noticeable percentage change within the first 5 minutes. This rapid increase contrasts with the more stable behavior of the All Securities group, which remains relatively flat throughout the 30-minute period.

Specific Points of Interest:

• Minute 0 to 10: During this period, the study group shows a rapid increase, with the average percentage change rising significantly. The standard deviation is wide initially, indicating high volatility.
• Minute 10 to 22: The increase in the study group continues but at a slower rate compared to the initial rise. The standard deviation for the study group stabilizes somewhat, indicating reduced volatility compared to the initial surge.
• After Minute 22: The divergence between the groups becomes prominent. The study group's increasing trend and expanding volatility contrast with the stability of the All securities group. The lack of overlap in standard deviations after this point underscores the distinct behaviors of the two groups.

The second chart evaluates those that quickly decline.

Key Observations:

• Initial Decline: The study group (blue line) exhibits a sharp decline from the opening price, indicating a significant drop in stock prices right at the beginning of the trading day. In contrast, the larger group of all securities (purple line) shows a much more stable and less volatile performance, staying close to the zero line with minimal change.
• Rates of Decline: The study group declines rapidly in the initial minutes, reaching a noticeable percentage change within the first 5 minutes. This rapid decline contrasts with the more stable behavior of the All securities group, which remains relatively flat throughout the 30-minute period.

Specific Points of Interest:

• Minute 0 to 10: During this period, the study group shows a rapid decline, with the average percentage change dropping significantly. The standard deviation is wide initially, indicating high volatility but narrows down as the decline stabilizes.
• Minute 10 to 22: The decline in the study group continues but at a slower rate compared to the initial drop. The standard deviation for the study group becomes more stable and narrower, indicating reduced volatility.
• After Minute 22: The divergence between the groups becomes prominent. The All securities group remains stable with minimal changes, while the study group's decline becomes more pronounced. The lack of overlap in standard deviations further emphasizes the distinct behaviors of the two groups.

In both scenarios the charts illustrate just how quickly volatile IPO securities move. Each sample group moved in excess of 10% in the first 20 minutes of trading. The risk of missed opportunity or quick loss is very apparent. At IPO Prophet we seek to develop systems to address these risks in a systematic way. In knowing what downside risks can be and recognizing when trading action looks quantifiably adverse, it becomes easier to step in to seize opportunity.