Employees Often Exercise Stock Options Early

According to economic theory, an employee given a stock option would be "irrational" to sell the option too soon before it expires. Models for pricing the value of options, in fact, typically assume they are held until the expiration date. In a study of eight companies with broadly granted options, Professors Steven Huddart and Mark Lang of the University of Michigan and the University of North Carolina looked at the behavior of 50,000 employees granted options. They found tremendous variation in when people actually exercised the options. Employees sacrificed half the value options would be projected to have based on the most popular option pricing model (Black-Scholes). While exercise patterns ranged considerably from company to company, significant upward movements in stock prices were a primary factor in explaining early exercise.

The results are important not only in understanding employee behavior, but also in pricing options for what will likely be required accounting footnote disclosures. Models now assume that the full value of the options is realized; in fact, the data show this does not typically occur.