What exactly is insider trading?

By Investopedia Staff AAA
A:

An "insider" is any person who possesses at least one of the following:

1) access to valuable non-public information about a corporation (this makes a company's directors and high-level executives insiders)

2) ownership of stock that equals more than 10% of a firm's equity

A common misconception is that all insider trading is illegal, but there are actually two methods by which insider trading can occur. One is legal, and the other is not.

An insider is legally permitted to buy and sell shares of the firm - and any subsidiaries - that employs him or her. However, these transactions must be properly registered with the Securities and Exchange Commission (SEC) and are done with advance filings. You can find details of this type of insider trading on the SEC's EDGAR database.

The more infamous form of insider trading is the illegal use of undisclosed material information for profit. It's important to remember that this can be done by anyone, including company executives, their friends and relatives, or just a regular person on the street, as long as the information is not publicly known. For example, suppose the CEO of a publicly-traded firm inadvertently discloses his/her company's quarterly earnings while getting a haircut. If the hairdresser takes this information and trades on it, that is considered illegal insider trading, and the SEC may take action.

The SEC is able to monitor illegal insider trading by looking at the trading volumes of any particular stock. Volumes commonly increase after material news is issued to the public, but when no such information is provided and volumes rise dramatically, this can act as a warning flag. The SEC then investigates to determine precisely who is responsible for the unusual trading and whether or not it was illegal.

To learn more about insider trading, check out the articles Uncovering Insider Trading, Delving Into Insider Investments and When Insiders Buy Should You Join Them?

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