In this blog post, we’ll discuss a vital process investment banks oversee during the first few days after a company gets listed on public markets Stock price stabilization.
This process seeks to keep the share price stable immediately after the IPO. But to explain stabilization Greenshoe and Overallotment, we’ll need to introduce a concept some of you may not be familiar with if you already know what taking a short or long position means.
Think of a situation when an investor expects a publicly traded stock to experience a price decrease in the short run since the investor is interested in maximizing her profit. She’ll borrow some of that company’s shares from another investor. Almost always an institutional one who owns these shares. She’ll borrow the shares for a fixed period of ten days and then sell the shares on the market, and in ten days the investor buys the shares on the market at the price they are sold.
In this way, the investor can give back the shares to the organization that lent her the shares. Paying a small commission for borrowing shares they would have held anyway. If in the meantime the share price declines, the investor earns a positive difference from her short position. Let’s show how this happens with a numerical example.
If the original price at the time of borrowing the shares was $10, the investor could borrow the shares and sell them for $10 on the market. She pays a 50-cent commission to the organization that lent her the shares, and then ten days later, the investor finds out she was right and the company’s price per share drops to $7. She buys the borrowed number of shares on the market and gives it back. That’s a profit of $2.50 per share after the commission. On the other hand, if the share price had increased to $12, this would have resulted in a loss of $2.50.
This type of trading is similar to regular trading When you buy market shares, which are yours. But the outcome is reversed because the investor bets on a price decrease. Such an approach is called taking a short position because, in 99% of the cases, market participants using this strategy have a short-term investment horizon. On the other hand, taking a long position means that an investor buys a stock and expects the stock price to perform well over an extended period, and so in most cases, the investor intends to hold the security longer.
