What Is a Reverse Greenshoe Option?

A reverse greenshoe option, also known as an overallotment option, is a provision used by underwriters in the initial public offering (IPO) process. It is intended to provide increased price stability for the newly-listed security.

Reverse greenshoe options are similar to regular greenshoe options except that they are structured as put options rather than call options. In both cases, however, their objective is to promote price stability following the IPO.

Key Takeaways

  • A reverse greenshoe option is a method used by IPO underwriters to help reduce the volatility of the post-IPO share price.
  • It involves the use of a put option to purchase shares in the open market and sell them back to the issuer at a higher price.
  • The resulting buying pressure from the underwriter is intended to help mitigate against a downward slide in the share price.

Understanding Reverse Greenshoe Options

When participating in an IPO, the lead underwriter of the offering will typically assume the responsibility of ensuring the price of the newly-listed security remains within reasonable bounds in the weeks following the IPO. To accomplish this, the terms of the underwriting agreement will include a provision that allows the underwriter to buy or sell shares from the issuer in such a way as to dampen the volatility of the share price.

In a typical greenshoe option, this is done through the use of a call option written by the issuer or primary shareholder(s) that allows the underwriter to buy a given percentage of shares issued at a lower price to cover a short position taken during the underwriting.

By contrast, a reverse greenshoe option consists of a put option written by the issuer or primary shareholder(s) that allows the underwriter to sell a given percentage of shares issued at a higher price should the market price of the stock fall.

For example, suppose the IPO price is set at $20 per share and the underwriter is given a "reverse greenshoe" put option with a strike price of $20 per share. If the share price declines to $10 per share following the IPO, the underwriter could purchase shares at the market price of $10 and then exercise its put option in order to sell those shares back to the issuer at $20 per share. By buying in the open market, the underwriter would help soften the downward slide in the post-IPO stock price.

Real World Example of a Reverse Greenshoe Option

The term "greenshoe" arises from the Green Shoe Manufacturing Company, which is now known as the Stride Rite Corporation. Founded in 1919, Green Shoe was the first company to implement the so-called greenshoe clause into their underwriting agreement. Technically, the legal name for this clause is an "overallotment option" because, in addition to the shares originally offered to them, additional shares are set aside for underwriters. 

This type of option is the only way an underwriter can legally stabilize a new issue after the offering price has been determined. The Securities and Exchange Commission (SEC) introduced this option to enhance the efficiency and competitiveness of the IPO fundraising process.