Cashing In on Managerial Malfeasance: A Trading Strategy around Forecasted Executive Stock Option Grants

This study examined the profitability of a trading strategy that exploits the manipulation of stock prices around the grant date of executive stock options. The strategy generates annualized abnormal returns of 1.4–5.2 percent net of transaction costs and is relatively unaffected by the Sarbanes–Oxley Act of 2002.Executive stock option compensation creates an incentive for managers to temporarily manipulate their companies’ stock price downward before an option grant. This incentive stems from the fact that the option strike price is typically set equal to the market price of the stock on the date the option is granted and the payoff at exercise equals the difference between the stock price and the strike price. Therefore, because option value and strike price are negatively related, executive stock options are more valuable the lower the stock price (and thus the strike price) on the grant date. Previous researchers have argued that managers act on these incentives and manipulate stock prices downward by accelerating the release of “bad news” before an option grant and delaying the release of “good news” until after an option grant. Consistent with this argument, others have documented significant negative abnormal returns in the days preceding executive stock option grants and significant positive abnormal returns following such grants.In our study, we designed and evaluated a trading strategy that seeks to profit from managerial manipulation of stock prices around the date of option grants. We limited our strategy to companies that award options on apparently fixed schedules (i.e., we eliminated companies that backdate or randomly award stock options) so that we could form reasonable expectations about upcoming award dates. This approach was critical because option grants are seldom announced before the fact. To maximize the potential profitability of our trading strategy, we wanted to take a short position before an expected option grant and reverse it immediately afterward. We implemented our trading strategy as follows. First, we identified companies as granting on fixed schedules when they awarded stock options for at least four consecutive years within one week of the preceding year’s option grant date. Second, we defined the most recent calendar date of an option grant for these “fixed granters” as the expected option grant date for the following year. Next, in the year after which the company established itself as a fixed granter, we took a short position during the 20 trading days before the expected grant date to take advantage of any downward manipulation of the stock price preceding an option grant. Finally, on the expected grant date, we reversed our short and took a long position for 60 trading days to take advantage of the reversal of any downward manipulation of the stock price.We compared the returns from our trading strategy with those of three different benchmarks: the return predicted by the market model, the return on the S&P 500, and the return predicted by the Fama–French three-factor model. Depending on the benchmark, we found that the 81-day holding period abnormal returns from our trading strategy are statistically significantly positive and range from about 1 percent to 2.15 percent. We estimated that the transaction costs for our strategy—which requires four trades—are 0.56 percent, so the strategy is implementable to generate abnormal returns of about 0.44 percent to 1.59 percent in excess of transaction costs. On an annualized basis, our trading strategy generates abnormal returns of approximately 3 percent to 6.5 percent (1.4 percent to 5.2 percent net of trading costs).We further assessed the profitability of our trading strategy for two separate periods: 1996–2002 and 2003–2008. The results are similar for both periods, which suggests that traders did not learn from the pattern of abnormal returns in earlier years to arbitrage away abnormal returns in later years. The results also suggest that the passing of the Sarbanes–Oxley Act of 2002, which includes stricter disclosure requirements for stock option grants, did not significantly affect the profitability of our trading strategy.