How Security Markets Work
New issues of common stock and preferred stock are sold in the
primary markets. In other words, the primary market is the market
in which new securities are sold to the market. The secondary markets
are where existing securities are traded among investors
through an intermediary.
PRIMARY MARKETS AND INITIAL PUBLIC OFFERINGS (IPOS) FOR COMMON STOCKS
New issues of stocks that are sold for the first time are initial public
offerings (IPOs). If a company that has already issued stock on the
market wants to issue more stock, it is referred to as a new issue.
eBay, Yahoo!, and Google were extremely successful IPOs on the
market in the late 1990s and early 2000s.
Most IPOs and new issues of stocks are marketed and sold
through underwriters (brokerage firms). Most of the underwriting
of common stocks takes one of three forms: negotiated arrangement,
competitive bid, or best-efforts arrangement. These different
arrangements are due to different terms and conditions agreed to
between the issuing company and the brokerage firm and do not
have a direct effect on the individual purchaser of the securities.
What you should know about buying new issues or IPOs is that
you do not pay a commission to buy the securities from underwriters.
The issuing company pays these fees.
Companies issuing securities in the primary market are required
to provide investors with a legal document, called a prospectus, so that
they can make prudent investment decisions. The prospectus is a formal
document related to the offering of new securities that provides
information to investors interested in purchasing the securities.
Returns from IPOs
IPOs generally give investors a wild ride in terms of returns. In
September 1998, eBay, an Internet company, was brought to market
at an issue price of $18 per share, and 31⁄2 months later the stock was
trading at $246. This 1,267 percent return took place over 3 1⁄2
months. Not all IPOs are like eBay, though. Generally, many IPOs
increase in price on the first day of trading owing to the heavy
demand for the stocks, but over long periods of time they tend to
underperform secondary issues. A study done by Christopher B.
Barry and Robert H. Jennings (1993) showed that the greatest
return on an IPO is earned, on average, on the first day the stock
comes to the market. Professor Jay Ritter (1991) concluded that an
IPO’s long-term performance is much poorer than that of companies
trading on the secondary markets (existing shares traded on
the markets). Ritter updated his research to include returns from
IPOs during the five years after issuance from 1970 to 2002, indicating
that IPOs underperformed other firms of the same market
capitalization by an average of 4.2 percent, excluding the first-day
return. In addition, the Wall Street practice of imposing penalties
on brokers who sell their clients’ shares immediately after issue is
disadvantageous for small investors (Zweig, Spiro, and Schroeder,
1994, pp. 84–90). Table 7–1 offers an explanation of how IPO shares
are allocated and who gets them.
One reason for a decline in price of IPO shares after a period
of time might be that company insiders sell their shares. Executives,
managers, and employees of a company can purchase their own
stock or are granted options on the stock. Insiders usually must
hold the stock for a period of time, known as a lock-up period, which
typically ranges from three months to a year. When the lock-up
period expires, company insiders can sell their shares, which can
cause the share price to fall.
How IPO Shares Are Allotted and Who Gets Them
Investors of all types have tried diligently to obtain IPO shares because of the
spectacular returns earned by many IPOs over short periods. Therefore, if
individual investors have a hard time getting these shares at issue, who does
The issuing company distributes a portion of the IPO to its friends and family
members. The underwriter also allocates its shares to privileged investors,
such as institutional investors and mutual funds. Smaller allocations go to the
brokerage firms’ wealthy investors. The average small investor is positioned low
on the institutional totem pole.
No rules or regulations govern the allocation process. The National Association of
Securities Dealers (NASD) bars investment banks from selling these IPO shares
to senior officers who are in a position to direct future business back to their
investment banks (underwriters).
The IPO market has some disadvantages that you should be
aware of before investing:
* Institutional investors get very large allocations of shares,
leaving a small percentage available for individual investors.
* Institutional investors are privy to better information than
* Individuals rely on information primarily from a prospectus;
institutional investors can attend road shows and meet
company executives. Cheat sheets, provided by brokerage
firms to their preferred institutional clients, contain management
forecasts and income projections that are not part
of a prospectus. Companies are reluctant to include cheat
sheets in their public documents; if a company misses its
published projections, it might be vulnerable to lawsuits.
* Individual investors are penalized for selling their shares
immediately after issue, although institutional investors are
allowed to quickly “flip” their shares.
If you want to participate directly in the IPO market, you
should be aware of these disadvantages. You might consider
instead investing in mutual funds that concentrate on IPOs.
Categories in Trading Mistakes
Lack of Trading Plan
Planning plays a key role in the success or failure of any endeavor
Using too much Leverage
Determining the proper capital requirements for trading is a difficult task
Failure to control Risk
Refusing to employ effective risk control measures can ensure your long-term failure
Lack of Discipline
A lack of discipline can destroy even the most talented and best prepared trader
Useful Advices to Beginning Trader
You can control your success or failure
All about Stocks
Encyclopedia about Stocks. That you should know about Stocks before starting
All terms about Forex market