When underwriters help a company go public, one of their main goals is to make sure the stock does not suffer from too much selling pressure on day one.

Underwriters mostly rely on an over-allotment of shares to stabilize a stock’s price when it opens for trading, but extraordinary circumstances sometimes push underwriters to use an unconventional tool called a “naked short.”

Because IPOs rarely fall in price on the first day of trading, underwriters rarely ever need to use the “naked short” to prop a stock price up, but underwriters will occasionally include the option if there’s a chance of the stock selling off on the first day of trading.

In the case of the high-profile Uber (UBER) initial public offering (IPO), underwriters reportedly relied on the naked short to support the stock at its offering price of $45 a share. Those tools only helped so much — shares of Uber had fallen over 10% by the end of the second day of trading.

But in order to understand the naked short sell, it’s important to know about the first line of defense in keeping a stock price up: the “greenshoe” option.

Greenshoe

When an underwriter prepares an IPO, they will allot a specific amount of shares that will be sold in the offering. But an underwriter will include a provision that allows the company to offer a 15% bonus allotment that can be sold in the open market and then bought back for the purposes of stabilizing the stock price.

For example, ABC Company might offer 1,000,000 shares at $100 a share. But when the stock finally goes public on IPO day, the underwriters call sell an extra 15% (150,000 shares, for a total of 1,150,000 shares). The underwriters will then buy back those 150,000 extra shares if the price starts sinking, in an effort to prop the stock back up.

This over-allotment is called a “greenshoe,” named after the Green Shoe Manufacturing Company (now called Stride Rite), which first employed the strategy when it went public.

The naked short

But if the greenshoe is not enough, underwriters can turn to another back-up: the naked short.

In a regular short position, person A borrows one share of the ABC Company and sells it to person B at $100. If the stock sinks to $90, person A then re-buys one share and gives it back to the lender, making a profit of $10.

In a “naked” short, person A never owned the share at all, and instead sells the promise of delivering one share of the ABC Company to person B at $100. If the stock sinks to $90, person A quickly re-buys one share and gives it back to the lender, still making a profit of $10.

The naked short is possible because there is a three-day settlement period for actually handing over the stock. In theory, if the short seller can buy back one share within the three-day settlement period, they can deliver on the stock and close their position. If the seller does not have the share by the time the settlement period is over, a “failure to deliver” occurs and the trade falls short.

The Securities and Exchange Commission made the practice illegal in the aftermath of the financial crisis, saying that naked short selling had the “abusive” potential of creating a misleading impression of the market for a given stock.

But naked short selling is still legal for IPO underwriters. The logic is that the underwriters, who created the new shares to begin with, should have no issue failing to deliver since they plan on quickly re-buying the shares in order to prop the stock back up anyway.

Worth all the effort?

In the case of Uber, the greenshoe and the naked short were not able to save the stock from slipping over 10% by the end of its second day of trading.

Thomas Boulton, a professor who studies IPOs at Miami University, told Yahoo Finance that stock support from an underwriter is fairly brief.

“The evidence seems to suggest the price support lasts for no more than a couple of weeks,” Boulton said. “Much of the price support takes place right out of the gate but in some issues the price support will last for multiple days.”

Although seen as a means to reduce volatility for a brand-new security, stabilizing efforts could also be seen as a legal means of price manipulation that lends itself to ambiguity over how involved underwriters be in propping a stock up. In 1999, brokers for the now-defunct Duke & Co. firm were indicted for keeping the prices of at least six small stocks at artificially high levels.

There’s also the question over the financial gain that lead underwriting banks stand to gain from naked short positions, since selling stocks at a high price and rebuying them at a lower price leads to profits for the bank.

But a 2007 paper from Oxford University professors Tim Jenkinson and Howard Jones notes that the naked short actually incentivizes underwriters to do what’s in its clients’ best interests: preventing their stocks from plummeting on day one. Jenkinson and Jones also point out that the profits from their short positions are offset by the negative reputational effects of having an underwritten stock fall.

Still, naked short selling remains a bit of a mystery in the IPO process because unlike the greenshoe, those positions are not public knowledge. The size of the naked short in the Uber IPO, for example, is unknown. And tracking the trades in the market are difficult because the positions were likely closed very quickly.

The Jenkinson and Jones paper, released well before the current chapter of unicorn IPOs, observed at the time that “in many cases,” the lead underwriter’s short position is greater than the size of the greenshoe.

As other large companies prepare to go public, underwriters are likely to incorporate at least a greenshoe to make sure their stocks are stable out of the gate. As for the naked short, it will take a little more scrutiny to find out.

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Brian Cheung is a reporter covering the banking industry and the intersection of finance and policy for Yahoo Finance. You can follow him on Twitter @bcheungz.

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