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Reference points

Professor Mark Lang (University of North Carolina, Chapel Hill) and I previously examined how rational economic considerations 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. These findings are published in our paper, Employee stock option exercises: an empirical analysis.

Rational economic factors (such as a desire to diversify one's wealth, or a pressing personal need for cash) could explain these choices. We wondered whether psychological factors also play a role. In a paper with Professor Lang and Professor Chip Heath (a psychologist at Stanford), Psychological factors and stock option exercise, we examine how psychological factors influence exercise decisions.

Psychologists have found that people tend to evaluate their current situation in relation to a reference point. Likely, reference points for options depend on stock price movements after options are granted. Research on human learning and memory implies that options-holders 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." While these strategies may be common, they are not grounded in rational economic thinking.

Our data are employee-by-employee option grant and exercise records for 50,000 employees at seven companies spanning a period of approximately 10 years. The companies supplied these data on condition they and their employees remain anonymous. Four companies are listed on the NYSE (a manufacturer, two financial institutions, and a high-technology company) and three are recently-public Nasdaq high-technology companies. On any given date, the typical employee in our sample holds exercisable, in-the-money options from between two and three option grants. The median value of the option if exercised immediately and the median expected present value are $9,070 and $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 constitutes 35% of base salary.

The data are consistent with options-holders relying on reference points in making exercise decisions. We examined employee reference points defined over various periods of time from three months to two years. We found that when the stock price is above a one-year maximum (that is the green line in the graph), 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 options-holders set a reference point based on the maximum stock price that was achieved within the previous year. They are more likely to exercise the stock price rises above 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 currently is greater if the stock price trended downward during the period from 12 to 6 months ago.

In terms of your own financial planning, ask yourself whether exercising vested options when your company's stock price spikes is a rational financial decision or a response to a less well-defined psychological urge.

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Steven Huddart
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
(814) 863-0048
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was last updated on Tue, Aug 21, 2018.
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