What is Insider Trading?

| February 5, 2013 | Hit The Market | , | 2 Comments

Insider trading is the buying and selling of a corporation’s stock by company insiders who have access to non-public information.

While insider “trading” refers to illegal stock trading, insider “transactions” are perfectly legal if the insider has followed the proper steps.

The Securities and Exchange Commission (SEC) makes the distinction between legal and illegal trading:

The legal version is when corporate insiders—officers, directors, and employees—buy and sell stock in their own companies. When corporate insiders trade in their own securities, they must report their trades to the SEC.

Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.

Since “insider transactions” must be disclosed to the public through SEC filings, investors can keep an eye on legal trading done by company insiders to see how the management team feels about the future. In general, accelerated buying by company insiders is a good sign. Accelerated selling is, well, not such a good sign.

Here is a famous example of illegal trading activity: In late 2001, the CEO of a pharmaceutical company learned that its main product had failed to gain FDA approval. With the failure of the drug trial, the CEO knew the stock of his company was about to plummet. He, and other company insiders, sold millions of dollars in stock before the news was made public. He even instructed his father and daughter to sell over $10 million worth of stock just a day before shares plummeted.

This was the same insider trading scandal that landed Martha Stewart in prison for five months. Her stockbroker had also become aware of the drug’s failure to gain FDA approval. Since Martha Stewart sold shares of that company based on this non-public information, she was found guilty beyond a reasonable doubt.

Interestingly, Martha Stewart only avoided a little over $45,000 in losses by placing these illegal trades. Hardly worth it, considering that she spent five months in jail, five months on house arrest, and saw her reputation tarnished.

Insider “trading” is illegal and cheats the general population of investors. But insider “transactions,” which are disclosed to investors through publicly available SEC filings, are perfectly legal. In fact, keeping track of which company insiders are buying and selling shares of their own company’s stock can be an indication of things to come.

Imagine that a CEO has been slowly accumulating shares of their company’s stock for years. As part of his or her annual pay package, the CEO receives a certain number of shares and the CEO hasn’t been buying additional shares during their career.

What if the CEO suddenly starts buying up additional shares? Isn’t this a good thing? In most circumstances, strong insider buying like this is seen as a positive sign.

The Bottom Line

Insider trading isn’t something to like or dislike, it is something to keep an eye on. If you are thinking about investing in a company because you think it is undervalued, check the recent insider transactions. If company insiders have been buying additional shares in recent months, it could be that these insiders share your view that the company is undervalued.

Insider selling isn’t always a bad thing but context is very important. Some companies choose to pay their executives largely in stock. If a company executive is selling stock to serve as his or her salary, this shouldn’t be construed as a negative sign for the company. However, if a company insider, who has previously been very consistent with their insider transactions, suddenly changes their buying and selling patterns, you should wonder why.

Most online brokerage firms and websites like Yahoo Finance offer detailed information about recent insider transactions. This data can help you quickly spot trends in insider buying or selling that are worth paying attention to.

Using this insider trading data and some simple addition, you should be able to find out what percentage of a company is owned by its management and insiders. If the people who know the most about a company are choosing to invest heavily in that company, it is often a very positive sign.

Insider trading records don’t tell the whole story, but they are an important component of understanding the risk and opportunity associated with any potential stock investment.

Read more about risk, price vs. value, and much more on Investor Bistro.


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