Understand the Risks of Green Shoe Option Before You Invest

Traders normally stumble upon the enticing descriptions of various IPO instruments being bestowed with unusual names such as ‘green shoe’ or ‘call put option’. 

These two instruments perform an indispensable function for market stabilization and risk management, but their interpretations become paramount in arriving at sound investment decisions. 

In this article, we discuss the green shoe option, its advantages and disadvantages for investors, and any considerations that may be paramount before placing money into it. We shall also convey that IPO investments relate to call-and-put options.

What is the Green Shoe Option?

A green shoe option (also called an “over-allotment option”) permits underwriters to sell more shares than were initially offered for sale by the issuing company during an IPO. This mechanism serves to stabilize the stock price during the earliest days of trading, and it takes its name from Green Shoe Manufacturing Company, the first company to use that strategy.

Hence, under the provisions of the green shoe option, the underwriters can buy additional shares of stock from the issuer at the issue price, that being up to 15 percent of the share amount from the issuer, provided that the demand for that IPO exceeded the expectations outlined in pricing and marketing. 

Such a motive was to counteract the pressure from excess demand and stabilize stock price movements so that the stock may have a less turbulent entry into the market.

How Does the Green Shoe Option Works?

1. Initial Offering

The company fixes a certain amount of shares to be issued, and the underwriters establish demand.

2. Over-allotment

When demand exceeds supply, underwriters sell an additional 15 percent through the green shoe option.

3. Price Stabilization

When the price of an offer drops below the issue price, the underwriters buy back shares to stabilize the price.

4. Exercise of Option

If the stock performs well, the underwriters may buy the extra shares the issuer offers at the given price, thereby increasing the total amount of shares sold.

Benefits of the Green Shoe Option

• Market Stabilization: Prevents extreme price volatility during the stock’s early trading days.
• Confidence in the Investor: This Creates an incentive for retail and institutional investors to be involved in the IPO.
• Prevention of Overpricing: Prevents the stock from being priced at grossly inflated or deflated levels right after listing.
• Liquidity Support: This adds liquidity by allowing investors to buy and sell shares more smoothly.

Risks Related to the Green Shoe Option

The green shoe option has various risks that should be considered by investors, notwithstanding the advantages:

1. Price Manipulation Concerns

Green shoe options can stabilize a stock price. However, underwriters will buy back shares in the open market which creates an incorrect sense of demand for the stock among investors, thereby inducing stock manipulation.

2. Green Shoe and Overvaluation Risk

In the event of the stock being highly oversubscribed and where the underwriters exercise the green shoe option, the stock price may be temporarily pushed up. When demand for an offering is speculative instead of fundamentally founded, heavy declines may follow, leading retail investors to suffer.

3. Bear Markets Present Limited Cushion

While the green shoe could help with some temporary price stabilization, the price stabilization it provides would not protect the IPO investor in a drawn-out bear market. Declines will manifest for most IPO stocks if the market heads south, regardless of the initial stabilization measures.

4. Potential Conflicts of Interest

The underwriters’ reputation and fees depend on a successful IPO, so they have a vested interest in maintaining stock prices. This interest may lead to price stabilization activities being performed for the benefit of institutional investors at the cost of retail investors.

Call Put Options in IPO Investing

Both call put option must be accounted for by the IPO investors if they are seeking to offer themselves either risk coverage or speculative opportunities about movements in the price of the shares.

Call Options

The right to buy a stock at a certain price at any time during a specified time frame. If investors expect IPO stock to go up, they may buy call options to profit without actually buying shares.

Put Options

They give investors the right to sell shares at a certain price. Put options are used by investors hedging against the stock price going down after an IPO.

How Call and Put Options are Related to the Green Shoe Option?

If investors trust a stock’s price will increase after going public, buying call options enhances their profits without sinking much capital into the stock. 

Conversely, those with concerns about a possible decline could use put options to cover their loss, paralleling how underwriters stabilize prices with the green shoe option. 

Price stabilization by the green shoe option will have an indirect impact on the pricing of options since it influences the volatility of stocks and the short-lived stability of prices.

Conclusion

Although the green shoe option is an important instrument to stabilize IPO prices, it raises many concerns and risks. Investors should be aware of the possibility of price manipulation, overvaluation, and conflicts of interest when venturing into an IPO. Options should also be understood as a tool that plays a useful role in mitigating stock price fluctuations.

Investors must research the IPO, investigate the company’s fundamentals, and weigh the prevailing market conditions. While the green shoe may help the short-term picture, long-term investment viability hinges on the strength of the company and the markets.