What Is An IPO Grey Market?

Companies that decide to launch an IPO, generally decide to test waters in the grey market. They do so for various reasons such as to check the demand for the impending IPO or to gauge what the IPO valuation should be.

This unregulated marketplace was established to trade stocks waiting to be listed on larger exchanges or to trade those unable to qualify for the big exchanges.

Not every stock is associated with an IPO. Some grey market stocks are issued by start-up or spin-off companies looking to test the waters before spending the time and money to be listed on a major exchange.

There might also be stocks which at one point traded on the big, recognized exchanges but have since suffered financial misfortunes or failed to meet Securities and Exchange Commission requirements.

Although grey markets are not illegal, they are not authorized or controlled in the usual way. That means SEBI, stock exchanges and brokers are not involved or back these transactions taking place in the grey market. Therefore, there’s little legal recourse available to parties if the stock tanks.

The grey market is an over-the-counter market where dealers may execute orders for preferred customers as well as provide support for a new issue before it is actually issued.

This activity allows underwriters and the issuer to determine demand of the company. This helps them get a sense of what the IPO valuation can be.

The grey market avoids advertising and frequent trading activity records cannot be found either. In many cases, stocks on the grey market are too new to have histories.

Why People Trade In Grey Markets

Grey markets have been existing for a long time and many investors and traders vouch by it. That’s because it can be an excellent opportunity for retail investors and traders to purchase the shares before they are listed, if they feel that the stock is going to increase in value. It is pretty much a demand and supply situation.

Another reason is that if a customer wants to exit the IPO even before it is listed, the grey market provides her a way out.

It also allows people to buy IPO shares even though they missed the application deadline or if they want to buy even more shares than the IPO application could provide them with.

Why Companies Allow Grey Market Trading

Grey market trading happens before the company is listed. Many times, underwriters use trading on these markets to gauge the correct IPO valuation. These markets help underwriters get an idea of the demand and what could be the path for the company once it gets listed.

Also, there is at least a six-day delay prior to the listing of shares on the stock exchanges. Since time is money, underwriters are anxious to begin selling and therefore, are willing to sell shares in the grey market.

How To Gauge The Grey Market IPO

There is no definite answer to this question. The way to handle this is to not jump in immediately. Instead, let other people trade and before you check the pricing. However, since the market is unregulated, detailed information is also not available many times.

Types Of Grey Market Trading

Trading in an IPO grey market involves two types of trading:

Trading (selling or buying) allocated IPO shares before they list on stock exchanges Trading (selling or buying) IPO applications at certain rate (premium)

Trading IPO Shares

Lot of times, grey markets allow people to trade in IPO shares before they are listed in the stock exchanges. This is done at a premium called grey market premium (GMP). This market is also known as the over-the-counter market.

GMP is the additional amount over the IPO price that investors are willing to pay to buy the shares.

If the premium is high, more investors are likely to get involved with the IPO whereas a low or a negative premium indicates low interest and consequently fewer investors. In fact, grey market premium helps underwriters to gauge the IPO price.

GMP are also attached with words ‘buyer' and ‘seller'. They tell the price either at which buyers are willing to buy shares or the price at which sellers are willing to sell their IPO shares.

Certain examples will help in understanding the concept better:

Positive grey market premium: Suppose the issue price of Company XYZ is Rs 350. Grey market premium of XYZ is Rs 80 (buyers). In the given situation, the premium is positive. Because of positive premium, the buyers are ready to purchase the shares of XYZ at Rs 350 + Rs 80 = Rs 430.

Negative grey market premium: Suppose, in this situation the grey market premium of XYZ is Rs -30 (sellers). The issue price is Rs 350. Since the grey market premium here is negative, it means that the sellers are ready to sell the shares at a discount of Rs 30. Hence, they are ready to sell the shares at INR 320.

These premiums are not constant and they keep changing according to the changing demands. These fluctuations continue till the stock is listed on the exchange for trading.

In spite of the grey market premium being an indicator for the trend, many investors/traders feel it should not be taken too seriously. The reasons are as follows:

The grey market is too small. The sample size is effectively insignificant and might not dictate the true demand. The grey market is unofficial and the transactions are not backed by regulations. Hence, manipulations are possible. There are other major factors such a fundamentals and economic trends which might dominate the direction of the stock. IPOs are often used for profit booking on the listing day. Due to heavy selling, stocks might even go below the issue price. If an investor invests just looking at the grey market premium, this might be a deal breaker.

Trading IPO Applications

One can also trade IPO applications on the grey market. This typically happens after the application window is closed but before the allotment takes place.

It is very rare for someone to trade IPO application post-allocation, as it would be better to trade IPO shares by that point.

As the allocation algorithm treats each retail application equally, buying IPO applications on the grey market acts as a way to increase the chances of share allotment.

It is important to remember here that this trade is not backed by SEBI and the buyer is trusting the seller to honour her word.

At the time of allotment, the seller will transfer all the shares allocated to her to the buyer, regardless of what the listing price may turn out to be later.

In return, she accepts Kostak over the issue price on the spot. Again, nothing is issued by the grey market to indicate this sale.

What Is KOSTAK?

Kostak (or price of application) is the premium amount at which IPO applications are being traded for in the grey market.

In other words, Kostak rate is a profit one makes by selling his/her IPO application even before allotment or listing of the issue.

It is especially useful for people who do not want to take a risk with IPO allotment or listing gains.

In simple terms, if you have a demat account but you don't want to subscribe an IPO, you can sell your application to an interested buyer in the grey market. Under these circumstances, your application will be subscribed by the buyer on your behalf and she will pay you a certain amount for that. The profit you make is kostak rate.

Kostak rates vary depending on the IPO. The advantage is that the buyer may gain or lose her money, but you will get a fixed kostak rate.

A Quick Recap

A grey market IPO is useful for several parties: companies issuing an IPO, their underwriters, start-ups, formerly big companies and most importantly, traders.

Although an unauthorized market, traders vouch for it because they can buy shares that haven’t been listed on the exchanges and there are possibilities of the share price swelling in future.