What Is an IPO Grey Market?

Companies that plan to launch an IPO generally decide to test the 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 emerged as a way to trade stocks waiting to be listed on major exchanges or to trade those unable to qualify for the big exchanges.

Not all grey market stocks are linked to IPOs. 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, recognised exchanges but have since suffered financial misfortunes or failed to meet Securities and Exchange Board of India (SEBI) requirements.

Although grey markets are not illegal, they are not authorised or controlled in the usual way. That means SEBI, stock exchanges and brokers are not involved in 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 issuers to determine the demand for the company’s shares. This helps them get a sense of what the IPO valuation can be.

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.

How Does an IPO Grey Market Work?

An IPO grey market allows investors to bid on shares of a company before its initial public offering (IPO). It operates as an unofficial platform that provides an indication of the expected listing price and demand for the IPO.

In the grey market, brokers buy shares from employees and early investors of the company and then sell these shares to other investors before the official listing. The trading price set in the grey market acts as a reference for investors to gauge the potential price when the IPO opens for public subscription. However, the grey market does not involve the company itself issuing new shares.

The legality of IPO grey markets varies across different countries. While they can help discover a company's true valuation, lack of regulations also makes them risky for retail investors. The prices in the grey market may be highly volatile and not fully reflective of the demand.

Why People Trade in Grey Markets

Grey markets have existed for a long time, and many investors and traders vouch for 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 them 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.

What Is Grey Market Premium (GMP)?

Grey Market Premium (GMP) is the extra price investors are willing to pay for a company's shares before they are officially listed on the stock exchange through an Initial Public Offering (IPO). It reflects market sentiment and demand for the shares in the unofficial, unregulated “grey market.” A high GMP usually indicates strong investor interest and the likelihood of the IPO opening at a higher price than the issue price. Conversely, a low or negative GMP may signal weak demand.

Example: Suppose a company’s IPO is priced at ₹100 per share. In the grey market, investors are trading these shares at ₹120 each. Here, the GMP is ₹20 (₹120 – ₹100). This suggests strong demand, and when the IPO officially lists, the stock might debut above ₹100, possibly around ₹120, depending on market conditions.

GMP is purely indicative and can change rapidly; it is not regulated and does not guarantee listing gains.

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 the path could be 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, observe others trading first, then review the pricing before making a decision. However, since the market is unregulated, detailed information is often unavailable.

How Are Grey Market Trades Settled?

Grey market trades are settled between brokers and investors directly, unlike the actual stock market, where the clearing corporation settles trades.

When an investor places an order to buy shares on the grey market, the broker will source the pre-IPO shares from employees or early investors and deliver them to the investor while receiving payment in return. The entire settlement happens outside of the stock exchange.

Since grey markets are unregulated, there are higher counterparty risks. Investors do not acquire ownership rights in the company until the official listing, and shares purchased on the grey market are not added to the demat account. Settlement typically happens a few days before the IPO listing when brokers register the shares in the investor's demat account after buying them in the public issue.

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 a certain rate (premium)

Trading IPO Shares

Often, grey markets enable people to trade in IPO shares before they are listed on the stock exchanges. This is done at a premium called the grey market premium (GMP). This market is often considered a type of 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 negative premium indicates low interest and consequently fewer investors. In fact, the grey market premium helps underwriters gauge the IPO price.

GMPs are also attached to the words ‘buyer' and ‘seller'. They tell the price 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 ₹350. Grey market premium of XYZ is ₹80 (buyers). In the given situation, the premium is positive. Because of the positive premium, the buyers are ready to purchase the shares of XYZ at ₹350 + ₹80 = ₹430.

• Negative grey market premium: Suppose, in this situation the grey market premium of XYZ is – ₹30 (sellers). The issue price is ₹350. Since the grey market premium here is negative, it means that the sellers are ready to sell the shares at a discount of ₹30. Hence, they are ready to sell the shares at ₹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 transactions are not regulated. Hence, manipulations are possible.
  
• There are other major factors, such as fundamentals and economic trends, that 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

Traders 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 their word.

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

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

Advantages of Trading in the Grey Market

Here are the key perks of trading in the grey market:

• Price Discovery: Trading in the grey market helps investors identify the potential listing price of an IPO before it officially enters the stock exchange. Demand and supply forces in this informal market reflect investor sentiment, often signalling whether the stock may list at a premium or discount.

• Early Liquidity: The grey market provides liquidity before official listing by allowing investors to sell their IPO allotments or applications in advance. This helps investors who require immediate cash, without having to wait for the stock to be listed on the exchange. It also benefits those who prefer to lock in profits early, rather than taking on the risk of uncertain market performance after listing, offering a practical advantage to cash-seeking participants.

• Risk Transfer: Investors use the grey market to transfer risk by selling their IPO allotment rights in advance. By doing so, they eliminate exposure to uncertain price movements on listing day. Buyers in the grey market willingly assume this risk in expectation of profit, creating a win-win situation for both parties.

• Market Testing: The grey market enables informal testing of demand before a company officially lists its shares. If premiums are consistently strong, it signals the IPO has a good chance of success. Conversely, weak activity highlights lower enthusiasm, often prompting investors to adjust their bids.

• Premium Capture: Sellers in the grey market can capture potential listing gains upfront by selling their allotments at a premium. This allows them to book profits before the stock is even listed on the exchange. By doing so, they avoid uncertainty surrounding listing-day volatility.

Risks of Trading in the Grey Market

Trading in the grey market comes with the following risks:

• Price Volatility: Grey market trading lacks formal regulation, which often leads to sudden and extreme price swings. Investors may face unpredictable losses as prices can fluctuate based on rumours, speculative demand, or unofficial supply changes. Unlike regulated exchanges, grey markets do not have mechanisms like circuit breakers to stabilise prices, making trading highly risky and potentially eroding capital rapidly if market sentiment shifts unexpectedly.

• Legal Uncertainty: Transactions in the grey market operate in a legally ambiguous environment. Regulatory authorities do not officially recognise these trades, meaning investors may lack legal protection if disputes arise. Contracts, delivery guarantees, or rights to assets might be unenforceable in courts. Engaging in grey market trading exposes participants to the risk of fines, penalties, or regulatory scrutiny, making it a legally precarious avenue for investment.

• Counterparty Risk: Grey market trades often occur directly between buyers and sellers without intermediaries. This increases the likelihood of encountering unreliable counterparties who may default on obligations, fail to deliver assets, or manipulate trades.

• Information Asymmetry: Grey market participants often have limited access to verified information. Price movements and asset availability may rely on insider knowledge, rumours, or unofficial sources. Retail investors without specialised insights may make decisions based on incomplete or misleading data, increasing the risk of poor investment choices.

• Price Manipulation: Informal grey markets are vulnerable to manipulation by large participants. Since there are no oversight mechanisms, influential traders can create artificial demand or supply, artificially inflating or deflating prices. Unsuspecting investors may buy at inflated prices or sell at undervalued levels, leading to substantial losses.

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, the Kostak rate is the profit one makes by selling their IPO application even before allotment or listing of the issue.

It is especially useful for individuals who prefer not 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 to an IPO, you can sell your application to an interested buyer in the grey market. Under these circumstances, your application will be subscribed to by the buyer on your behalf, and they 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.

What Is Subject to Sauda?

Sauda refers to the speculative trading activity that happens in the unofficial grey market for IPOs in India. When a company is about to go public, its shares sometimes start trading in the grey market, where brokers facilitate transactions between interested buyers and existing shareholders.

The pricing and demand discovered in the sauda or the grey market are non-binding and considered speculative since it does not involve any formal issuance of shares by the company. The trading prices often see high volatility as various investors try to buy or sell shares in anticipation of the listing gains.

Small retail investors are more likely to fall prey to overpricing and manipulation in sauda. While it helps generate hype for the IPO, sauda remains an unregulated activity and lacks transparency. The only official price discovery happens once the public issue opens and the company allots shares to investors through a regulated process following the IPO price band and allocation norms.

What Factors Affect IPO GMP in the Stock Market?

The overall market sentiment at the time of the IPO plays a major role in determining the grey market premium (GMP) for an initial public offering (IPO). When broader markets are bullish, IPOs tend to have higher GMP as investor appetite and risk appetite increase. Bearish markets, on the other hand, see lower GMP for IPOs as investors become more risk-averse. The fundamentals of the company, such as its financial health, growth prospects, and competitiveness, also drive interest in the IPO and impact the GMP. Companies with strong fundamentals and healthy financials can sustain a higher GMP as investors remain confident about future growth.

The demand and subscription levels during the IPO play a significant role in determining the GMP. Higher oversubscription from qualified institutional buyers (QIBs) and retail investors leads to better price discovery and results in a higher GMP. Low demand, on the other hand, dampens the GMP.

The perceived valuations, listing gains expected, promoter reputation, and hype also influence GMP as optimistic investors are willing to pay a premium to buy pre-IPO shares in anticipation of strong returns on listing.

Can You Use Grey Market Information When Applying for an IPO?

Using grey market information when applying for an IPO is not recommended. The grey market is an unofficial and unregulated system where shares change hands between brokers and investors prior to the IPO. The pricing and demand indicators from such trades should be taken with caution as they can be manipulated. Grey market premiums tend to be highly volatile as speculative trading causes inflated prices far from the fundamentals. Basing your IPO application on such unreliable signals is risky. Moreover, regulators discourage using grey market data to make investment decisions regarding IPOs. The only valid price discovery happens once the company publishes the price band and allotment happens through the stock exchanges after the issue opens.

Relying solely on grey market movements can result in making ill-informed decisions under the influence of hype or manipulation. Fundamentals, financials, valuation and long-term prospects should guide your IPO application, not just grey market trends. While grey markets can help gauge initial enthusiasm, their unofficial nature makes them an unreliable metric when applying for shares in an IPO through proper channels. You should depend on your own research and analysis.

A Quick Recap

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

Although an unauthorised 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.