0On hope that you are comfortable with the terms
- IPO
- Options
- Underwriters
- Follow-on
- Shorting
Green shoe option is a method of over allotment option, embedded in the IPO. An explanation regarding the practical use would give a better picture.
Story Line (Naive Definitions)
- X owns a company ,he is going for his first IPO
- X fears that prices may go far below the offer price once trading started on the equity in Capital market
- This situation can lead investors to off load investments ,bring price down uncontrollably
- So he approaches his underwriter and tells that he want to cover that risk
- Underwriter provides him with the offer of Green shoe option
Now, you are clear about the risk of X regarding price & investor behavior, let’s call this risk ‘K’, this risk will be covered by Underwriters. But they don’t do it without covering their exposure to risk.
Now lets’ see how they operate under the norms of Green Shoe Option.
- To manage K ,they adopted Green Shoe Option in IPO
- This would give underwriters the power to short sell a portion of stocks above the actual issue planned (Usually 15%,can vary)
- So Underwriters in IPO sells 115% shares ,instead of 100% planned (if without Green Shoe Option )
Now let’s analyze the market standing of IPO after issue .
Shares Out standing
- 100% Long Positions - Regular Investors
- 15% Short Positions - Under writers
Once shares are started trading two things can happen in IPO in general
Share prices
- Go Up
- or
- Go Down
When Share price Go Down
Risk situation expected by X, underwriters manages the risk by buying shares at Market price or Offer price which is pre-planned; this gives a better support level in stabilizing stock price, and helps to churn out unusual sell off.
When Share Price Go Up
Risk K ,not taking place would put the underwriters in bad position to buy back the shares from market at Market Price or above offer price ,which would compromise their cash position.
So they execute Green Shoe Option, which helps them to buy shares from company at offer price. Hence it helps them closing their short positions without any further adjustment to the existing cash position.
