During IPO, to cover oversubscription for new securities issued, the underwriter is granted an option for a limited period of time to purchase additional securities from the issuer at the issue price (usually 15% of the offering amount). This common feature of the IPO market is also referred to as a greenshoe opt ion and is considered as a pr ice stabilization mechanism.
Aggarwal (2000) finds indeed that “underwriters manage price support activities by using a combination of aftermarket short covering, penalty bids, and the selective use of the overallotment option.” Ellis et al. (2000) also find that the lead underwriter uses the overallotment option for less successful IPOs to reduce his inventory risk.
Cotter and Thomas (1998) examine the ways underwriters use the overallotment option and find that underwriters always profit when they make full use of the overallotment. They also suggest that the Nasdaq should reexamine the size of the overallotment options and require disclosures concerning their uses.