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What is a greenshoe and how does it work?

This is a jargon term used in the Australian stock market. It is also used in the US market and maybe elsewhere. The mechanism is used rarely in Australia but is far more common in the US.

A greenshoe is probably best described as legal market manipulation. In Australian its use requires clearance by the Australian Securities and Investments Commission (ASIC). It is used to assist in the management of large floatations of companies (also known as Initial Public Offerings or IPOs).

The greenshoe mechanisim involves the float managers being permitted to sell as much as 15% more shares in a float than are being issued. This means that the float managers will be short immediately after the new issue begins trading on the secondary market (stock exchange). Therefore, the float managers need to buy shares in the stock being floated after it begins trading.

Float managers are not premitted under the mechanism and the corporations law to manipulate the share price after the stock begins trading at a price that is higher than the IPO price. This means that they must buy at or below the float price. The greenshoe mechanism provides a means to enable investors wishing to sell at the float price after being allotted shares in the IPO. If more are bought than the lead managers were short in the float, this mechanism may also be used to provide liquidity for large institutional investors who wish to buy more shares in the stock than were allocated to them in the IPO.

There is usually a 30-day time limit on a greenshoe.