Subsequent stock price moves

While it is plausible and consistent with much empirical evidence that top executives often possess price-relevant information, it is less clear whether lower-ranking employees also are aware of and act on such information.

Low firm-wide stock option exercise in one month is associated with higher-than-expected stock returns in the subsequent six months: When option exercise (adjusted for other factors affecting exercise) is high, the stock underperforms, on average, by 4.3% over the next six months. When exercise is low, the stock outperforms, on average, by 6.0% over the next six months. Thus, the aggregated exercise decisions of many employees do, on average, contain substantial information about firm prospects. Exercise activity predicts stock returns best over the 3 months after the exercise decision.

The exercise decisions of relatively junior employees predict future prices at least as well as the exercise decisions of more senior employees. There are several potential explanations. First, lower-level employees, collectively, may know more than a much smaller group of senior employees, and option exercise may serve to aggregate the price-relevant component of this information in the same way that many noisy observations may yield a more precise posterior than a smaller number of less noisy observations. Second, the most senior employees may face constraints that limit their ability to profit from private information that lower-level employees do not face. For instance, under section 16 of the Securities Exchange Act of 1934, the option exercises of every corporate insider are made public and may be scrutinized by regulators and market observers for inappropriate use of material non-public information, which may serve to limit illegal insider trading.

How can the information imbedded in stock option exercise be put to use?

Corporate management may benefit from tracking stock option exercise, since it appears to convey information about the corporation's near term prospects. Further, market regulators may wish to consider rules requiring timely disclosure of aggregate option exercise. Because fairly junior employees have access to price-relevant information, arguments in favor of requiring potentially informed individuals to disclose their trades could be extended to lower-level employees. Persons outside the company could use such disclosure to infer sooner information that is currently impounded in price over a six-month period. The collection and publication of stock option exercises has the potential to enrich all market participants' information because an individual might reevaluate his private assessment of the company's prospects in light of the stock option exercise decisions of others. There may be other benefits to employees from this disclosure change as well: given such rules, and to the extent the stock appreciates rapidly in response to a disclosure of low exercise in one month, employees would be able to reap their options gains sooner than otherwise. Moreover, this disclosure rule would not prevent employees from exercising their options in advance of anticipated price declines. Were the prompt public disclosure of detailed exercise data to be mandated, one needs to consider whether firms would choose to limit employee exercise activity.

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