The Logic (or Not) Behind Exercising Options
I was curious about how executives of public companies decide to exercise their stock options? Do they use financial logic, or do they base their decisions on the short-term price movement of the underlying stock?
A study I read examined how rational economic motives drive decisions to exercise stock options. * Conducted by Professors Mark Lang (University of North Carolina Chapel Hill) and Steven Huddart (Penn State University), found that the majority of option holders make their exercise decisions based on the stock prices above or below their reference point (perceived value).
How are these reference points set? The study found that they are a response to the average or extreme stock prices attained over a period of time. For example, “I’m not going to exercise now because the stock is at $55 and last year it was at $65” or “when the stock gets to its high of $70, I’ll exercise.”
Other findings: When the stock price rose above a one year maximum, exercise activity doubled regardless of when the options expire; a 10% rise in stock price in a single week drove a 22% increase in exercise activity the following week. The research concluded the past year’s stock price history has a strong effect on exercise behavior. Individuals tend to focus on the one-year horizon, because the financial press typically reports the 12 month high.
Instead of a rear view, I would encourage executives to consider the long-term prospects of their companies and base their decision to exercise options on financial logic. After all, stock options have significant economic value that shouldn’t be sacrificed because of short-term price movement of the stock. Yet, the NASPP’s (National Association for Stock Plan Professionals) 2007 survey revealed that 51% of participants exercise their stock options in less than 2 years even though most stock options have an expiration of 10 years.
*The research examined 50,000 employees over a 10 year period.
Equity Compensation Advisor’s Moral: Basing decisions to exercise stock options on short-term stock price movement is short sighted.
Securities offered through LPL Financial Member FINRA/SIPC