Saturday, May 19, 2012

Facebook and the Greenshoe option.

On Friday, Facebook's IPO provided us with a fascinating case study on the effects of price support.

Here's the graph of the stock price for the day (note that it didn't start trading right away because of a snafu with Nasdaq's computers).


You'll see that the price basically bottomed out at $38, but never went below $38, which is where the price support kicked in.

With new buyers of the stock trying to sell, the underwriters posted massive buy limit-orders at $38 (a limit order is an order to buy at a specific price).  Known as "price support" in the jargon (or more politically correctly "price stabilization") this is part of the underwriting service which, in exchange for their fee, the underwriters pledge to try to keep the price at or above the initial offer price.  Doing so  ensures that shareholders who bought the stock at the initial offering don't get taken to the cleaners which would be bad for everyone.

You can see the effect of the underwriting support here - where there is a huge block of trades right at $38 and the result of the "epic battle" here.

You might be thinking that the underwriters just got the short end of the stick here - they've had to buy huge amounts of the stock at $38, knowing full well that the stock is likely to go down further on Monday when the market opens again.  But you'd be wrong.   At the end of the Friday, it is unlikely that the underwriters are actually holding any Facebook stock.  

The way the underwriters do this is to use two tricks.  First is the Greenshoe option (named for the company where it was first used, which is now StrideRite).  The Greenshoe, or more technically, over-allotment option lets the underwriter sell 15% more shares than are listed in the offering.  The second trick is that the underwriter is allowed to sell shares that it doesn't own - it can create a naked short position - so in effect, 15% of the shares sold to the public don't actually exist.  (a naked short is when you sell something you don't own, as opposed to a regular short where you first borrow the stock and then sell it.)

So the underwriter has sold 15% extra shares (which don't exist!).   If the price goes up, then the underwriter will exercise the Greenshoe option and get another 15% of real shares from the issuer to cover those naked short shares.  But, if the price falls, as was the case for Facebook, the underwriter will just start buying back shares to cover the naked short.   In theory the underwriter can buy back 15% of all the shares issued,  and at the end of the day have a net position of zero.

The flexibility of being able to take a naked short position combined with the Greenshoe option ensures that the underwriter can provide aggressive price support without actually having to end up owning a ton of stock.

But on Monday it will be a different story.   Once the underwriters have exhausted the 15% that they shorted, they will be unlikely to take one for the team and continue to provide support.   My prediction is that the price will fall, because fundamentally, I don't think Facebook is worth $100 billion.