This is how an IPO greenshoe works
There is often confusion around the workings of the over-allotment option; there shouldn’t be.
It’s nearly the end of the year, so how about an alternative award?
Award category: Least-Understood-And-Yet-Easy-To-Understand-Capital-Markets-Thing
Winner: The Greenshoe
As the recent Aramco IPO has shown yet again, the greenshoe (or over-allotment option, to give it its proper name) still proves confusing to some. That's surprising, because there's not really a whole lot to grasp.
Underwriters routinely over-allocate IPOs, typically by 15%. They do this by short-selling the extra shares, borrowing them from some investors in order to allocate them to others. This means the underwriters have a short position (at issue price) that at some point they will have to close out.
The reason the underwriters do all this is to give them the flexibility to stabilize the market price of the shares once they start trading. Since they are already short, they can happily buy stock in the market up to the size of their short position, knowing that those shares are already spoken for.
If the shares fall in the secondary market when it starts trading, the underwriters can cover their short by buying shares in the market and delivering them back to the investors they borrowed them from. If they do this they make a profit, since they have allocated the shares at issue price but are buying them in the market at below issue price.