Why do corporate insiders sell shares before receiving stock option grants?

Corporate executives, directors and officers often receive stock options as part of their compensation packages. These option grants are designed to align insiders’ interests with those of shareholders by rewarding them when company value increases.

But a longstanding question remains: Why do many insiders sell company shares shortly before receiving new option grants?

In the paper, "Insider risk aversion and trade informativeness: evidence from pre-option-grant selling," published in the journal Finance Research Letters, Parianen Veeren, an assistant professor of finance at the John Molson School of Business, and his co-authors examine whether these transactions are driven by private information about future company performance or by a more mundane concern: managing personal financial risk.

The findings suggest that insiders are primarily rebalancing their portfolios rather than acting on private information, similar to delta hedging. The evidence points to risk management as the dominant explanation for pre-grant selling activity.

Balancing incentives and risk

Stock options allow holders to purchase shares at a predetermined price and become valuable when the share price exceeds that price. Although intended to promote long-term value creation, they also increase insiders’ firm-specific risk exposure.

Because senior executives often already hold significant amounts of company stock, additional option grants can make their personal wealth heavily concentrated in a single firm. Selling shares before receiving a grant can help restore a preferred level of diversification.

Researchers compared this risk management explanation with an alternative hypothesis: that insiders may be selling because they possess material non-public information about their companies.

The distinction is important.

If insiders are selling to reduce risk, those transactions should not be followed by unusually poor stock performance. If they are selling because they anticipate negative news, subsequent stock returns should be significantly lower.

A large-scale examination of insider trading activity

The research draws on U.S. insider transaction and stock-option-grant data from 1996 through 2023.

The dataset combined insider filings collected by the London Stock Exchange Group (LSEG) with stock return information from CRSP, accounting data from COMPUSTAT and analyst forecasts from IBES. Insider transactions are required to be reported to the U.S. Securities and Exchange Commission within two business days. The timing of insider trading is governed less by law than by firm practice: most firms impose blackout windows.

The researchers also accounted for factors that influence trading behaviour, including corporate blackout periods and pre-scheduled trading plans.

Selling activity rises before option grants

The first stage of the analysis examined trading patterns around option grant dates.

The researchers found that net insider selling reaches its highest level during the quarter preceding an option grant. This pattern reflects either increased selling activity, reduced purchasing activity or a combination of both.

To determine whether these trades were informative, the study employed an event-study approach that measured stock performance following insider purchases and sales. Using the market model parameters estimated from 320 trading days ending 20 days before each insider trade, the researchers measured abnormal and cumulative abnormal returns over the 60-day post-trade window. This window was chosen to reduce the impact of blackout windows.

Consistent with previous research, insider purchases were generally followed by positive abnormal stock returns, while insider sales were followed by negative abnormal returns. These findings suggest that insider transactions often contain valuable information about future performance.

Pre-grant sellers are different

The most important finding emerged when researchers focused specifically on insiders who sold shares repeatedly in the 60 trading days leading up to an option grant.

If these individuals were acting on private information, the stocks they sold would be expected to perform especially poorly afterward.

The opposite pattern appeared.

The usual stock-price movements following insider trades were significantly weaker among insiders who sold before receiving option grants. Their sales were associated with less negative post-trade performance, while their purchases were associated with less positive performance.

In other words, their trades appeared to contain less information than those of other insiders.

According to the researchers, this is what would be expected if insiders were rebalancing their portfolios rather than trading on superior information. The researchers concluded that this pattern was consistent with delta-motivated portfolio rebalancing and inconsistent with informed selling.

Not all insiders trade alike

The study also found meaningful differences across executive roles.

Trades executed by chief financial officers and board chairs tended to be more informative and more profitable. By contrast, trades by CEOs, presidents and other corporate officers were generally less informative.

These patterns remained consistent across several additional tests and alternative measures of pre-grant selling activity.

Implications for investors and regulators

Overall, the evidence indicates that insider selling before stock-option grants is largely motivated by a desire to manage risk rather than exploit private information.

The findings suggest that insiders are reducing portfolio concentration rather than undermining the incentive effects of stock-option compensation.

While the results are consistent with risk management, the researchers note that other factors, such as liquidity needs, tax considerations and pre-arranged trading plans, may also play a role. However, the conclusions remain robust even after accounting for scheduled trading plans.

The study contributes to a better understanding of insider trading behaviour and suggests that pre-grant stock sales may not be as concerning to investors as they initially appear.

Read the cited article, "Insider risk aversion and trade informativeness: evidence from pre-option-grant selling," in Finance Research Letters.