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A greenshoe option (sometimes green shoe, but must legally be called an "over-allotment option" in a prospectus) allows underwriters to short sell shares in a registered securities offering at the offering price. The greenshoe can vary in size and is customarily not more than 15% of the original number of shares offered.
The greenshoe option is popular because it is one of a few SEC-permitted, risk-free means for an underwriter to stabilize the price of a new issue post-pricing. Issuers will sometimes not include a greenshoe option in a transaction when they have a specific objective for the offering and do not want the possibility of raising more money than planned. The term comes from the first company, Green Shoe Manufacturing (now called Stride Rite Corporation), to permit underwriters to use this practice in an offering.
Underwriter short selling and price stabilization 
Greenshoe option 
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The mechanism by which the greenshoe option works to provide stability and liquidity to a public offering is described in the following example: A company intends to sell one million shares of its stock in a public offering through an investment banking firm (or group of firms which are known as the syndicate) whom the company has chosen to be the offering's underwriter(s). When the stock is being offered for public trading for the first time, the offering is called an initial public offering (IPO). When the stock is already trading publicly and the company is simply selling more of their non-publicly traded stock, it is called a follow-on.
The underwriters function as the broker of these shares and find buyers among their clients. A price for the shares is determined by agreement between the company and the buyers. When shares begin trading in a public market, the lead underwriter is responsible for helping to ensure that the shares trade at or above the offering price.
When a public offering trades below its offering price, the offering is said to have "broke issue" or "broke syndicate bid". This creates the perception of an unstable or undesirable offering, which can lead to further selling and hesitant buying of the shares. To manage this possible situation, the underwriter initially oversells ("shorts") to their clients the offering by an additional 15% of the offering size. In this example the underwriter would sell 1.15 million shares of stock to its clients. When the offering is priced and those 1.15 million shares are "effective" (become eligible for public trading), the underwriter is able to support and stabilize the offering price bid (which is also known as the "syndicate bid") by buying back the extra 15% of shares (150,000 shares in this example) in the market at or below the offer price. They can do this without the market risk of being "long" this extra 15% of shares in their own account, as they are simply "covering" (closing out) their short position.
When the offering is successful, demand for shares causes the price of the stock to go up and remain above the offering price. If the underwriter were to close their short position by purchasing shares in the open market then the underwriter would incur a loss by purchasing shares at a higher price than the price at which they sold them short.
This is where the over-allotment (greenshoe) option comes into play: the company granted the underwriters the option to purchase from the company up to 15% more shares than the original offering size, at the original offering price. By exercising their greenshoe option, the underwriters are able to close their short position by purchasing shares at the same price for which they sold-short the shares, so the underwriters do not lose money. If the underwriters are able to buy back all of the oversold shares at or below the offering price (to support the stock price), then they would not need to exercise any portion of their greenshoe option. If they are able to buy back only some of the shares at or below the offer price (because the stock eventually goes higher than the offer price), then the underwriters would exercise a portion of greenshoe option to cover their remaining short position. If the underwriters were not able to buy back any portion of the oversold shares at or below the offering price ("syndicate bid") because the stock immediately went and stayed up, then they would completely cover their 15% short position by exercising 100% of their greenshoe option.
SEC regulations 
The SEC also permits the underwriters to engage in naked short sales of the offering. The underwriter creates a naked short position either by selling short more shares than the amount stated in the greenshoe option, or by selling short shares where there is no greenshoe option. It is theoretically possible for the underwriters to naked short sell a large percentage of the offering. The SEC also permits the underwriting syndicate to place stabilizing bids on the stock in the after-market.[dead link] However, underwriters of initial and follow-on offerings in the United States rarely use stabilizing bids to stabilize new issues, and instead engage in short selling the offering and purchasing in the after-market to stabilize new offerings. "Recently, the SEC “staff has learned that in the US syndicate covering transactions have replaced (in terms of frequency of use) stabilization as a means to support post-offering market prices. Syndicate covering transactions may be preferred by managing underwriters primarily because they are not subject to the price and other conditions that apply to stabilization."
Naked short selling and syndicate covering purchases 
By definition of a naked short position, the only option the underwriting syndicate has for closing a naked short position is to purchase shares in the after market. Unlike shares sold short related to the Greenshoe option, the underwriting syndicate risks losing money by engaging in naked short sales. If the offering is popular and the price rises above the original offering price, the syndicate may eventually have no choice but to close any naked short position by purchasing shares in the after-market at a price higher than for what they sold the shares. On the other hand, if the price of the offering falls below the original offer price, naked short positions gives the syndicate greater power to exert upward pressure on the issue than the Greenshoe alone, and has the added benefit of being profitable to the underwriting syndicate.
Risk to investors 
Underwriters' abilities to stabilize a stock's price is finite both in terms of the number of shares the underwriters sold-short, and the length of time over which they choose to close their positions. "Regulation M defines this type of share repurchase as a syndicate covering transaction and imposes the same disclosure requirements as those imposed on penalty bids. Consequently, investors need not be informed that an offering is or will be stabilized by way of a syndicate short position. Rather, investors need only be exposed to language indicating that “the underwriter may effect stabilizing transactions in connection with an offering of securities” and a characterization of possible stabilization practices in the “plan of distribution” section of the prospectus." The SEC currently does not require that underwriters publicly report their short positions nor short-covering transactions. Investors who are unwary of underwriter stabilizing activity who choose to invest in what they perceive to be a stable issue can encounter volatility when the underwriters pause or complete any stabilizing activity. "Cast in the most negative light, price stabilization might be seen as a means of transferring risk to a relatively naïve segment of the investor population."
See also 
- Reverse Greenshoe, the converse of the greenshoe option
- "Excerpt from Current Issues and Rulemaking Projects Outline (November 14, 2000)". US Securities and Exchange Commission. US Securities and Exchange Commission. 14. Retrieved 16 September 2012.
- Staff (2012). "Company history". stride rite. Stride Rite Children's Group LLC. Retrieved 21 May 2012.
- "Regulation M, Rule 104". University of Cincinnati, College of Law.[dead link]
- Securities Law Update: 2. January 11, 2005 http://www.wilmerhale.com/files/Publication/481f105b-227b-49ac-b719-77f8c7771a6a/Presentation/PublicationAttachment/7b14be58-3fd0-4bfa-8502-7b6178c651b7/securitieslawupdateJan112005.pdf
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- Wilhelm, Jr., William (1999). Secondary Market Price Stabilization of Initial Public Offerings. Chestnut Hill, MA 02167: Wallace E. Carroll School of Management. p. 3.
- Wilhelm, Jr., William (1999). Secondary Market Price Stabilization of Initial Public Offerings. Chestnut Hill, MA 02167: Wallace E. Carroll School of Management. p. 4.
- Greenshoe Option Exercised in Polynt S.p.A. IPO
- BA-CA’s Greenshoe-Option not exercised
- CSA Staff Notice 47-302 Pre-marketing of underwriters’ options on bought deals