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When you see your company's stock price reach new highs, or when you want to get off the rollercoaster of volatility, it is tempting to exercise your options and sell the stock. While this decision might satisfy your short-term needs to do or buy something with the cash proceeds, it may not be in your best long-term financial interest.
Professor Mark Lang (University of North Carolina, Chapel Hill) and I have examined how rational economic motives drive decisions to exercise stock options. We found surprising evidence that many employees exercise their options years before expiration and thereby sacrifice a large fraction of their options' potential value.
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Employees who exercise their options years before expiration may sacrifice a large fraction of their options' potential value. |
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Rational economic factors (such as your desire to diversify your portfolio or a pressing need for cash) could explain these choices. We wondered whether psychological factors also play a role. In a project undertaken with Professor Lang and Professor Chip Heath (a psychologist then at Duke University but now at Stanford), we examined how psychological factors influence exercise decisions.
Your Value Function And Reference Points
While the terms value function and reference points may sound academic, hopefully my attempt at a plain-English explanation will make sense to you. Psychologists have found that people's choices are predicted by a concept called the value function. The value function relates a person's perception of utility, or value, to outcomes expressed as gains or losses relative to a reference point. People tend to evaluate their current situation in relation to a reference point.
We tried to find out whether option exercise decisions depend on the position of a stock price above or below a reference point. Another concept, known as prospect theory, tells us that people tend to avoid risks when their current situation is above their reference point (i.e., your company's current stock price is higher than the reference point) and tend to take risks when the stock is below their reference point (i.e., your company's current stock price is below the reference point).
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People are more likely to exercise when the stock price is above their reference point and are more likely to hold when it is below their reference point. |
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Holding an option is risky, but exercising an option yields a sure payoff. When applied to stock options, prospect theory suggests that people should be more likely to exercise when the stock price is above their reference point and to hold their options when the stock price is below their reference point.
Prospect theory does not specify how people set their reference points, which for employee stock options probably depend on stock-price movements after the options have been granted. Research on human learning and memory implies that optionholders are likely to set reference points in response to the typical (e.g., average or median) or extreme (e.g., minimum or maximum) stock prices attained over a prior period. For example, an employee might think: "I won't exercise now that the stock is $35, since last year it traded in the $40s," or "I'll exercise the next time the stock hits $50, since that is the high for our stock."
Our Research
Our data come from grant and exercise records for 50,000 employees at seven companies spanning a period of about 10 years. The companies supplied these data on the condition they and their employees remain anonymous. Four companies are listed on the NYSE (a manufacturer, two financial institutions, and a high-technology company). Three are NASDAQ high-technology companies that went public not long before the data were compiled.
On any given date during our study period, the typical employee in our sample held exercisable in-the-money options from between two and three option grants. The median value of the option if exercised immediately was $9,070, and the median expected present value was $15,415. The median employee in our sample earned about $75,000, and most earned between $50,000 and $100,000. The median expected value of options constituted 35% of base salary. (Statistics refresher: median is the middle value of a variable in a distribution of numbers. Thus, the median of 1, 2, 3, 10, and 100 is 3. The mean (or average) of these values is 23.2. Median is preferred to the mean as a measure of "typical" values since extreme values like the 100 in the example above do not affect it.)
Early Exercise Too Common
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Optionholders tend to base reference points on the maximum stock price that was achieved within the previous year. |
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The data are consistent with the assumption that optionholders rely on reference points in making exercise decisions. We examined employee reference points defined over various periods of between three months to two years. We found that when the stock price is above a one-year maximum, exercise activity roughly doubles. Exercise is significantly more sensitive to historical maximums than to medians and other percentiles. We interpret this as evidence that individual optionholders base reference points on the maximum stock price that was achieved within the previous year. They are more likely to exercise when subsequent price movements carry past their reference point.
In addition, separate from the reference-point effects, individuals clearly respond to stock-price trends. Controlling for rational economic factors, exercise is sensitive to recent stock-price performance. On average, a stock price run-up of 10% in one week results in a 22% increase in exercise activity the following week. Over longer horizons, this effect reverses: exercise activity is greater if the stock price trended downward during the prior 12 to 6 months.
What This Means For You
Our results accord with previous research indicating that investors monitor their investments over a period of about one year. In our data, the past year's stock-price history has a strong effect on exercise behavior. In part, it may not be surprising that individuals seem to focus on the one-year horizon, because the financial press commonly reports the 12-month high. Individuals, who may already be psychologically predisposed to focus on share price maximums, may find their predispositions enhanced because information about maximums is so readily available.
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Stock options have significant economic value that you do not want to sacrifice in a knee-jerk reaction to short-term price movements. |
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In your own financial planning, you may want to resist the urge to exercise and sell your vested options when your company's stock price spikes or enters a period of unsettling volatility. Remember that your stock options have significant economic value which you do not want to sacrifice in a knee-jerk reaction to short-term stock-price movements.
Almost all major online finance publications provide access to data, price charts, SEC filings, and analysts' forecasts on your company. Therefore, do the research and think seriously about the prospects for your company and its stock price over the full option term: you may be better off by waiting to exercise and sell the stock. In addition, try to think of your stock options as more than an investment or a source of cash: they are an ownership commitment to the company's long-term success.
Steven Huddart is a professor at the Smeal College of Business, Penn State University, and is one of the foremost academic researchers on stock compensation. He is on the Advisory Board of myStockOptions.com. The research in this article was published in the The Quarterly Journal of Economics, published by MIT Press. More of Professor Huddart's research is available on his website at Penn State.
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