Insider trading is a term that conjures up visions of illegal backroom dealing to buy and sell shares on information not available to the public. We have all heard of cases of illegal trading by corporate heads, but thousands of shares are bought and sold weekly by corporate insiders. This insider activity is perfectly legal as long as proper guidelines are followed. More importantly, it may be a valuable tool that helps you enhance your trades.

Definitions and Regulations

An insider is defined as an officer, director or owner of 10% or more of a class of shares in a corporation. This includes not only executives working for companies, but also other entities such as mutual funds, hedge funds or institutions that hold an amount equal to or greater than 10% of issued and outstanding shares.

Insiders are required to follow a strict set of rules as determined by the Securities and Exchange Commission (SEC), which includes reporting any trade in a timely manner. These rules have been toughened by the commission to define more clearly the circumstances under which insiders can trade, further tipping the scales in the public's favor.

In the wake of a number of Wall Street scandals, the U.S. Congress took part in a cleanup effort. Following the Enron debacle, Congress enacted the controversial Sarbanes-Oxley Act of 2002. This act mandated some powerful changes to reporting requirements. According to Lon Gerber, director of insider research with Thomson Financial, insiders are now required to report trades by the second day following the transaction, rather than the 10th day of the month following the trade as was required under the old rules. This reporting requirement goes a long way toward leveling the playing field for retail investors, making insider data a far more effective and timely tool in the process.

The Data
Figure 1 is a chart of the S&P 500. For figure 2, which is a bar chart of the ratio of insider shares sold to shares purchased in dollars, Thomson Financial provided insider-ratio data, which was then plotted using a spreadsheet program and then constructed into a bar chart.

120303_1.gif
Figure 1 – Weekly chart of the S&P 500 between 1997 and 2003. Numbers below price correspond to periods of low insider selling (high buying) and numbers above the price chart to periods of high insider selling in figure 2. Green lines are the 30-day highs and red lines, the 30-day lows. Chart provided by MetaStock.com

120303_2.gif

who followed the lead of insiders would have done quite well. When the ratio was at high levels, insiders were selling. Data provided by Thomson Financial.

A number of publications report insider transactions weekly from data provided by Thomson Financial. Two well-known sources are the Wall Street Journal's "Insider Spotlight" and Barron's insider transactions reports. Free insider transaction data on individual stocks is also available from sites like Yahoo! Finance. It is a simple matter to download the data each week into a spreadsheet and analyze it in your favorite charting program.

Analyzing the Insider Data
What was the relationship between insider transactions and stock price during the last six years? As we analyze these charts, we can determine whether high insider buying activity (when the ratio is extremely low) coincided with good times to buy in the market, and whether extremely high levels of insider selling activity (when the ratio is high) would have indicated that it's a good time to sell. As you can see from figures 1 and 2, traders who took cues from insiders when they bought (the sell/buy ratio was lowest) would have done quite well. Low points at points 1, 3, 5 and 7 (in figure 2) in the bull market, during which insiders were doing the largest amount of buying, would have netted copycat traders excellent returns. In the bear market, buying when insiders did at points 10, 12, 14 and 16 would have been a good strategy, even though you would have been trading against the trend.

What was the relationship between insider transactions and stock price during the last six years? As we analyze these charts, we can determine whether high insider buying activity (when the ratio is extremely low) coincided with good times to buy in the market, and whether extremely high levels of insider selling activity (when the ratio is high) would have indicated that it's a good time to sell. As you can see from figures 1 and 2, traders who took cues from insiders when they bought (the sell/buy ratio was lowest) would have done quite well. Low points at points 1, 3, 5 and 7 (in figure 2) in the bull market, during which insiders were doing the largest amount of buying, would have netted copycat traders excellent returns. In the , buying when insiders did at points 10, 12, 14 and 16 would have been a good strategy, even though you would have been trading against the trend.

What about selling when insiders did? According to Gerber, insider buying is a good signal to follow but insider selling is a little trickier. Insiders use restricted stock and options (issued in lieu of cash) to supplement or, in some cases, virtually replace standard paychecks, so using this data to determine when to sell is less exact. When insiders are buying their own stock, they do so because they believe the stock is going up. When they sell, however, they could be doing so for a number of reasons, not simply because they believe share value may drop.

Phil Roth, senior technical analyst for Miller Tabak & Co., frequent guest on CNBC and one of the first recipients of the Chartered Market Technician designation, had this to say in an e-mail responding to questions about insider sales:

"It is important to remember that most insiders are investors, not traders and they tend to buy shares in the company when they are cheap and sell when they are expensive. They are not as motivated by trends as are traders. Insider transactions have proven to be a better buy than sell indicator in my experience for the reasons you outline [in the two paragraphs above]."

This may explain why the market as represented by the S&P 500 (figure 1) did not drop significantly every time the insider sell/buy ratio hit high levels. By following the insiders' lead to sell as evidenced in figure 2 at points 2, 4 and 6, the trader would have been left out of the upside action that followed. Selling when insiders did would not have begun to pay off until the market began to turn at points 8 and 9.

During the bear market, selling with the insiders at points 11, 13 and 15 would have been a better strategy. Although an extreme level of insider selling in a bull market should not be used as an independent sell signal, it does beg the question: when insiders are unloading their shares like there is no tomorrow, is it really the best time to buy?

Conclusion – Remember to Use Other Tools
There is little doubt that as a sentiment indicator, insider buying and selling can be an effective trade confirmation tool when used in conjunction with other technical indicators such as trend lines and moving average crossovers by those who know how to read the signs.

It is imperative when using any sentiment indicator that a trend line be broken before a signal is acted upon, but it is clear that insider transactions have provided useful early warning signals in the last six years. For more on insider trading see When Insiders Buy, Should You Join Them? and Uncovering Insider Trading.

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