Some investors believe insiders have better info on the financial strength of a company
Insider trading can be legal or illegal depending on if the information used is public.
By Guy Avtalyon
Insider trading means that someone buys or sells stock based on information that is not freely available to the public. An insider could be someone from the management or simply someone who has access to non-public information. Insider trading can be legal or illegal depending on if the trade is executed on the information that is available to the public or not.
To be honest, everyone likes inside information and rumors. The problem is that most of the time they are just useless gossip. Still, we are all seeking the inside information and have something that is unknown to the majority. If it is possible, to no one.
When it comes to trading, this method of playing based on inside information is seen as insider trading. And it can be legal. Well, in some cases.
What is insider trading
Insider trading is trading based on information that is not accessible to the public. In most cases it illegal but in some specific cases, it is perfectly legal.
Insider trading is illegal when info is received from the insider and traded by traders who received that info and do it before info becomes known to the public. Insider will always give you a hot tip. But is it trustworthy? How will you know that?
That is a crucial difference for insider trading. To make insider trading, the secret information being given must be issued by an insider.
How to recognize the right insider?
Such has access to important non-public information about a company. Usually, it is some from the high-level executives, that have almost all the information about the company’s operations. Well, not all of the high-level management recognize the fiduciary interest and put it ahead of its own. Also, an insider very often owns a big stake in the stock.
In insider trading, an insider can be a trader who acts based on inside info that is not public data.
A legal insider trading
That is a completely different story.
According to the US Securities and Exchange Commission, insider trading can be legal but under some circumstances. For example when a CEO of some company purchases stock of the company he is obliged to report to the Securities and Exchange Commission. Also, legal insider trading is when workers exercise their stock options and buy shares of stock in the company that they work for.
How does illegal insider trading work?
Illegal insider trading is different than legal insider trading. But when it is in violation of the law?
For example, a friend of the CEO of a company heard that his friend could be accused of fraud soon. That info he uses to short shares of his friend’s company because he had the info about bad news that will occur in the future and that will cause the stock price to go down.
The other example is, let’s say, a board member of a company and woman. She knows that the merger is going to be declared in the following days and she assumes the company’s stock price will go up after that. What she is doing? She is buying more shares but not always in her name. Such can buy shares in her husband’s name or parents. That is illegal insider trading.
We are pointing only a few examples of illegal insider trading that may occur. Don’t do that, you may end up in prison.
Does insider selling suggest it’s time to sell?
Acts speak louder than words could ever do. Management is motivated to tell you why should you have to buy the shares of their company. But the insider will tell the true story about the company’s worth. A trend of selling or buying among insiders could give us a clue about the company’s future in the market.
The information that insiders are selling their stocks might give some benefits. Traders may use them to estimate where a stock’s price might go and how insiders price a stock since they have better insight. But remember all data must be public and available.
Anyway, be careful, it isn’t a precise formula. Think about the drawbacks too.
It will take you time and energy to find trends. Moreover, insiders are not always right. Don’t blindly believe in them because they might have some special reasons to sell or buy. And finally, you will get only a small part of large info and that may confuse you, so you may make a bad trade.
Where to find insider info
Speaking about the US stock markets, insiders are obliged to file SEC forms created particularly for insider stock trade reporting. But still, take your time to examine insider trades before you enter your buy or sell positions. Insiders’ information isn’t everything you need to make the right investment decision. You’ll need more.
The SEC made the EDGAR system to provide public access to the insiders’ activity. You can find it on the NASDAQ website. The point is to have the same data from a minimum of two insiders’ sources. Never rely only on one.
How to use insider information
Okay, your search gives you several reports on the company.
So, you can examine the data and find a trend. If your search of insider list displays buying actions, that should be a signal that the company’s management thinks the stock price will go up and want to profit from it as stockholders. But if you see that there is a lot of selling it is usually a sign that the stock price will go down. Insiders will always try to sell before stock prices drop. Anyway, it is only one info and you shouldn’t rely on just one. While you are looking for insider information try to read annual reports, statements, etc. Find other sources to support what you found as an insider trend. Then, you’ll be able to make a proper investment decision.
When you see the executives getting stock option grants and then selling a large part, you shouldn’t be worried. But if you see massive selling and without a visible cause, it’s time to think. Think because you have two options. One is to be a part of the crowd and sell your share or take advantage and buy a share at a bargain. And add to your portfolio to diversify it better.
Famous insider trading cases
The Wall Street Journal writer R. Foster Winans was sentenced to 18 months in prison in 1985 of giving information about stocks he was planning to write about. Two stockbrokers made about $690,000 thanks to his insider information. They were also sentenced.
Ivan Boesky paid $100 million to the Securities and Exchange Commission to compensate insider-trading charges that he made. He earned $50 million in illegal profits. Boesky pleaded guilty and was sentenced to 3½ years in prison in 1987.
Martha Stewart was sentenced. The problem was about her sale of ImClone stock based on a tip that she received from a broker at Merrill Lynch. She was sentenced to 10 months (prison and home confinement). Her stockbroker was also sentenced.
Also, a football player Mychal Kendricks was accused of insider trading after trading based on information he received from a friend. Friend? Yes, a friend who was a broker with Goldman Sachs.
And many others but don’t follow these examples, please. It’s too risky as you can see.
