Are executive stock option exercises driven by private information?
ABSTRACT In this study, we investigate the extent to which exercise of executive stock options is based upon private information. Contrary
to popular belief, we find that shares are held more than 30days following over a quarter of options exercised. Partitioning
the data, we find weak evidence that decisions to exercise and sell immediately are prompted by bad news and stronger evidence
that decisions to exercise and hold for at least 30days are prompted by good news. Enhancing the power of our tests by considering
several factors important to exercise decisions, we find that the higher the opportunity costs of early exercise as measured
by the time-value of options, the greater the trading profits to executives. We also find that the greater the disguise provided
by incentives to diversify and consume as measured by the depth of options in the money, the greater the trading profits to
executives who exercise and sell. Turning to non-exercise decisions, we find that a strategy of holding options rather than
shares to exploit good news yields positive abnormal returns consistent with theoretical predictions in the absence of dividends.
Are Executive Stock Option Exercises Driven by Private Information?
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Are Executive Stock Option Exercises Driven by Private Information?
We examine the extent to which executive stock option exercises may be driven by
private information. Contrary to the maintained assumption in prior literature that all
shares acquired though exercises are immediately sold, we found that no shares are sold
within thirty days following approximately half of the exercises. Generally speaking, we
find strong evidence that executives are exploiting positive private information when they
exercise the options but hold the shares beyond thirty days, and weaker evidence that
they are exploiting negative private information when they exercise the options and sell
the shares within thirty days. To increase the power of tests, especially on the negative
side, we consider several factors that may be important to executives when making
exercise decisions. Along with the exploitation of private information, these include
dividend and tax incentives to exercise early, opportunity costs of early exercise due to
the loss of time value in options, and reduction of diversifiable risk and concomitant
disguise in potential law suits offered by claims of diversification when options are
deeply in the money. We find strong evidence that executive’s trading gains are
positively correlated with time value and depth. Further findings support the conclusion
that executives exploit positive private information by holding options as well as by
exercising options and holding the shares.
Several factors come to bear for executives in deciding when to exercise stock
options and sell the stock acquired. Given that options represent a substantial portion of
their compensation, they must exercise the options and sell the stock in order to consume.
As well, executives are under-diversified with both their human capital and financial
assets invested in the same company, implying a strong diversification incentive for
exercise and sale. Countervailing the incentives to exercise and sell are the opportunity
cost of losing the time value of options and dividends and tax effects available through
exercise and hold.
Beyond these considerations, executives may seek to exploit private information.
If private information consists of bad news, then similar to consumption and
diversification they have incentive to exercise and sell before that news becomes public.
For good news, executives may either hold options or exercise options and hold the stock
until that news becomes public. Motivation for the latter is enhanced by the fact that
options are generally not dividend protected and gains on the subsequent sale of shares
from exercise, if held for a sufficiently long period, may be eligible for capital gains
A further consideration in exploiting private information is exposure to liability
for violating insider-trading regulations.2 Plausibly, insiders are less exposed to liability
from selling shares acquired through exercise of options deep in the money due to the
1 Under reasonable assumptions, MacDonald (2003) has shown that the opportunity cost for funds used to
purchase the stock outweighs the tax advantage per se implying that the tax aspect alone is insufficient to
prompt early exercise. Hence, dividends must be part of the motivation.
2 Under Section 10b-5 of the Securities and Exchange Act of 1934, insiders are prohibited from trading on
“material” non-public information. Notwithstanding this restriction, there is considerable evidence (see
Seyhun, 1998 and, more recently, Lakonishok and Lee, 2001) that insiders realize abnormal returns on their
trades, though principally on open market buys.
presence of other incentives such as consumption and diversification that may serve as a
defense. The deeper that options are in the money, then the stronger the diversification
incentive to sell. Thus, if an executive elects to exercise and sell in order to exploit bad
news, then greater depth may lessen exposure to liability under insider trading
regulations. A similar, though less persuasive, argument can be made for a dividend
incentive commingling with a strategy of exercise and hold in exploiting good news for
higher yield stocks.3 On one hand, the diversification and dividend incentives provide a
measure of disguise for private information-based decisions to exercise and sell or
exercise and hold, respectively. On the other hand, presence of these incentives is a
source of noise in attempting to detect the exploitation of private information.
In this study, we examine whether executives exploit private information when
exercising employee stock options while controlling for other factors that may be present.
To the extent that executives consider the above mentioned factors in making decisions
whether to exercise or hold their options, and, after exercise, whether to sell or hold the
shares, data on the status of the options and factors that seemingly influence executives’
decisions can be used to form more powerful tests by distinguishing option exercises that
are more likely to be motivated by private information.
Results in prior research on this issue are mixed. Carpenter and Remmers (2001)
found no evidence of private information for executive option exercises,4 while Huddart
and Lang (2003) found evidence that even employees, not limited to top ranked
3 Generally speaking, prosecution under insider trading regulations is less evident for buys than for sells,
suggesting that presence of other incentives for exercise and hold is not likely to be important as a defense.
4 Like Carpenter and Remmers (2001), we also examine a large dataset of executive option exercises,
including all transactions reported to SEC from 1996 to 2003 and collected by Thompson Financial. Unlike
their study, which analyzes only option exercises under an assumption that sales immediately follow, we
consider a broader set of factors that are likely to be important when executives make portfolio decisions
made possible by more extensive data.
executives, appear to possess private information when exercising their companies’ stock
options.5 Contrary to the maintained assumption in both studies, we find that not all
shares acquired through option exercises are sold immediately. In fact, all shares are sold
within thirty days of exercise for less than half of the firm-month observations in our
sample; and for close to half of the firm-month observations, no shares are sold within
thirty days.6 It is reasonable to conjecture that the motives behind decisions in these two
sub-samples that both feature executive option exercises should be quite different.
Indeed, we find that if we only condition our analysis of abnormal returns on the exercise
decision, consistent with Carpenter and Remmers (2001), then there is no trace of
negative abnormal returns; some post-exercise months even feature positive abnormal
returns. However, when we further partition the sample on whether the shares are
immediately sold, we find strong evidence that the keep-all sub-sample is associated with
positive private information, and weaker evidence that the sell-all sub-sample is
associated with negative private information.
The strong positive results and weaker negative results are in line with general
findings in the insider trading literature (e.g., Seyhun 1998, Ofek and Yermack 2000) that
generally attributes the weak results for insider selling to insider’s complementary
incentives to consume and diversify; as we acknowledge represent noise as well as
disguise.7 Without additional information about either the insider’s portfolio composition,
5 The Huddart and Lang study raises a natural question as to why transactions by top executives do not
entail private information if lower level employees do, since one naturally expects top executives to have
more ready access to private information. A caveat of Huddart and Lang’s study is that there are only seven
firms in the sample, while the Carpenter and Remmers study employ a large dataset of executive option
6 The remaining observations are where some but not all shares acquired through exercise are sold within
7 In keeping with the findings in these studies and the insider trading and employee stock options literature
in general, we find significant lagged market reactions subsequent to reports of transactions to the SEC,