The greenshoe option is a financial instrument that allows underwriters to regulate stock prices during an initial public offering (IPO). It is named after the original licensee - the Green Shoe Manufacturing Company of the United States. Initially developed and used by the company in the early 1960’s, it allows the issuer to increase the number of shares offered in a particular IPO by an agreed upon percentage for a specific period of time.

A greenshoe option provides the issuer with the ability to create price stability and liquidity for an IPO. The issuer is allowed to sell additional shares up to a certain cap of 15% over what was originally planned and listed in the prospectus. The additional shares that an issuer can issue are determined when the greenshoe option is set up. Investopedia notes that “while the issuer initially could have sold only the proposed amount of stock, it now has the option to sell up to 15% more, up to the greenshoe limit.” The underwriters have discretion over when to exercise the greenshoe option with the condition that they must offer the option to all qualified buyers or as otherwise required by the regulatory body overseeing the security exchange.

Greenshoe options are especially beneficial in a down market. The option gives the issuer the ability to buy shares to cover short positions if the stock price falls below its original offering price. With the greenshoe option, the issuer doesn't have to worry about owning more shares than it wants if the stock price rises.

The greenshoe option is a good solution for companies looking to achieve a good outcome for their IPO. As explained, it gives the issuer greater flexibility to create liquidity and price stability in the market. It also provides assurance against situations where the stock may fall below the offering price. The underwriters have discretion to exercise the greenshoe option whenever it is deemed necessary.