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How Psychology Could Make You Exercise Stock Options at the Wrong Time

How Psychology Could Make You Exercise Stock Options at the Wrong Time

April 15, 2024

Exercising stock options can become a fad — even for the most seasoned option holder. It’s commonplace to see employees rush to sell their stock when prices escalate or worry when the market is volatile. Unfortunately, many employees might sell their stock options prematurely and lose out on their long-term value in the process.

While relying on your gut feeling can provide temporary rewards, it could come at a great expense. Behind this erratic investment behavior are mental factors coupled with economic rationales, influencing the options exercise decision-making process.

Here are several ways psychology influences your stock option exercise behavior.

Reference Points and Value Function

Option holders have reference points or mental targets informing their exercise decisions dependent on the highest or lowest company stock price. A drop or increase in stock price below the reference point could prompt an exercise decision. Reference points provide value function on outcomes, designating them as wins or losses.

The prospect theory also upholds this supposition. It posits that option holders will avoid risks by exercising their options when the current stock price exceeds their reference point and take risks by holding options when prices plummet below the reference point. Thus, employees exercise when stock prices rise and hold options when prices fall below a reference point.

Option holders also use past stock prices as reference points in their exercise decision-making. If the current stock price is $35 and an option holder remembers it traded at $40 sometime last year, they are more likely to hold their options in anticipation of price increases.

There is no specific formula for setting reference points. Nevertheless, research analyzing 50,000 option holders exercising decisions in seven corporations over ten years established that the ideal moment for option holders depends on stock-price movements after options have been granted.

Early Exercising is Too Common

In addition to the past price reference point, the study established that employees are twice as likely to exercise their options when the current stock price supersedes the highest price it reached in the past year. The research analyzed employee exercise decisions between three months and two years. The one-year mark remains to be the sweet spot for many employees.

Furthermore, option holders care more about the previous year's maximum price than average prices or medians on the stock prices. This outlook suggests employees are chasing past highs, hoping prices will continue to escalate. Their probability of exercising intensifies with price escalations exceeding their reference point.

Aside from reference points, trends also inform option-exercising decisions. Employee exercise behavior is sensitive to current stock-price performance. If a stock price rises by 10% in one week, exercise activity will increase by 22% in the subsequent week. The opposite happens for longer past timelines ranging between 12 to 6 months. Exercise activity increases when stock prices drop.

Implications To Option Holders

The previous year's stock price performance is a significant reference point for most investors. In fact, the past year influences the current exercise behavior as option holders monitor their investments depending on last year's performance. Furthermore, many financial reports limit their data to the past 12 months, fueling investor hyper-fixation on the previous fiscal year. Financial sources also readily provide information on maximum stock prices, easing the process for people mentally inclined toward the highest share price.

Regardless of your gut feeling, you may want to hold your options when your company's stock prices escalate temporarily or become volatile. Stock options have significant value, but making rash decisions based on daily stock price swings can quickly erase those gains. 

Seasoned investors rely on facts to make informed investment decisions. Instead of relying on option holder trends, temporary market shifts, or unreliable reference points, review major online finance publications for your company's data, price charts, SEC filings, and analysts' forecasts. Due diligence is the only sure way to analyze your company's long-term prospects and stock price performance.

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