A greenshoe is also called an overallotment option, referring to the amount of shares offered in an initial public offering (IPO) or in a follow-on offering. If the demand for a security issue is higher than expected, the underwriter can sell additional shares up to 15% of the planned number of shares.
This greenshoe option shall provide more price stability and liquidity in the market. Since the underwriter wants to avoid that shares fall below their offering price, they often oversell the offering. So that when the shares tend to go down, the underwriter can buy back the oversold shares from the market.
In this case, the greenshoe option is abandoned. However, with rising prices of the stock the underwriter would have to buy back the shares at a higher price compared to the offering price.
To avoid this loss, the greenshoe option is exercised: the underwriter can buy additional shares from the issuer at the offering price. Another possibility without overselling the offering is the deferred settlement. Here an investor agrees to receive his shares from the offering not until the end of a lending period (e.g., a month).
If during that time the price of the shares needs to be stabilized, the underwriter will buy back the agreed number of shares from the market and if the price rises, the underwriter will purchase the additional shares at offering price from the company. The general term refers to the fact that the Green Shoe Company was the first to introduce that kind of option.