What Investors Can Learn From Insider Trading

It isn't a coincidence that corporate executives seem to always buy and sell at the right times. After all, the CEOs and CFOs of the world have access to every bit of company information you could ever want. However, the fact that company executives have unique insights doesn't mean that individual investors are always left in the dark. Insider trading data is out there for all who want to use it. This article will discuss what insider trading is, how we can understand insider trading, and where to find the relevant data.

What Is Insider Trading?

There are two types of insider trading: legal and illegal. First, let's talk about the illegal variety. Illegal insider trading is the buying or selling of a security by insiders who possess material that is still not public. The act puts insiders in breach of their fiduciary duty. As you can imagine, illegal insider trading is a definite faux pas for anyone closely involved with a company.

Key Takeaways

  • Illegal insider trading occurs when an individual within a company acts on nonpublic information and buys or sells investment securities.
  • Not all buying or selling by insiders—such as CEOs, CFOs, and other executives—is illegal, and many actions of insiders are disclosed in regulatory filings.
  • Directors and upper management are not the only people that can be convicted of insider trading; anyone with material nonpublic information can be convicted if they used the information to make illegal profits.
  • Large companies can have hundreds of insiders, which can make analyzing their buying and selling more difficult.

Anybody who has material and nonpublic information can commit the illegal act of insider trading. This means that nearly anybody, including brokers, family, friends, and employees, can be considered an insider.

Insider Trading That Is Illegal

The following are examples of illegal insider trading:

  • The CEO of a company sells a stock after discovering that the company will be losing a government contract next month.
  • The CEO's child sells the company stock after hearing from their parent that the company will be losing the government contract.
  • A government official realizes that the company will lose the government contract, so the official sells the stock.

The Securities and Exchange Commission (SEC) is extremely strict with those who trade unfairly and thereby undermine investor confidence and the integrity of the financial markets. Don't think that those who place the trades are the only guilty ones. If someone is caught "tipping" an outsider with material nonpublic information, that tipster can also be found liable.

Insider Trading That Is Legal

An important thing to emphasize here is that insiders do not always have their hands tied. Insiders can (and do) buy and sell stock in their own company legally all of the time; their trading is restricted and deemed illegal only at certain times and under certain conditions.

A common misconception is that only directors and upper management can be convicted of insider trading.

The SEC considers company directors, officials, or any individual with a stake of 10% or more in the company to be corporate insiders. Corporate insiders are required to report their insider transactions within two business days of the date the transaction occurred (before the 2002 Sarbanes-Oxley Act, the time frame was the tenth day of the following month).

For example, if an insider sold 10,000 shares on Monday, June 12, that person must report the transaction by Wednesday, June 14. Changes in insider holdings are sent to the SEC electronically as a Form 4, which details a company's insider trades or loans. A Form 14a, also filed by the company, lists all the directors and officers along with the shared interest that they have.

The kind of information found in filings is extremely valuable to individual investors. For example, if insiders are buying shares in their own companies, they might know something that normal investors do not. The insider might buy because they see great potential, the possibility for merger or acquisition in the future, or simply because they think their stock is undervalued.

One of the greatest investors of all time, Peter Lynch, was noted as saying that "insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise." Insiders are prevented from buying and selling their company stock within a six-month period; therefore, insiders buy stock when they feel the company will perform well over the long-term.

The SEC uses the Dirks Test to determine if an insider gave a tip illegally; the test states that if a tipster breaches their trust with the company and understands that this was a breach, that person is liable for insider trading.

Nejat Seyhun, a renowned professor and researcher in the field of insider trading at the University of Michigan and author of the book Investment Intelligence from Insider Trading, found that when executives bought shares in their own companies, the stock tended to outperform the total market. Conversely, when they sold shares, the stock underperformed the market.

Where to Find Insider-Trading Data

Access to data is definitely one way in which the Internet has revolutionized investing. With the click of a mouse, anyone can find the latest insider-trading statistics for just about any public company. Here are a couple of sites that provide insider-trading data for free:

  • Yahoo! Finance: Look up any quote on Yahoo! Finance and click on "Insiders" for a list of the latest trades. Some insider trading filings don't appear in databases until a month after the fact, but Yahoo! seems to have one of the most current data feeds.
  • SEC EDGAR Database: While not visually appealing, the EDGAR database is where trading data is first sent. To find the filings on the SEC website, you must search for the "central index key" (CIK) for the company. The CIK is used on the SEC's computer systems to identify corporations and individual people who have filed a disclosure with the SEC. Once you have the CIK, you can search for individual filings.

The Bottom Line

Insider-trading data is nothing new. Investors have been making investment decisions based on the actions of insiders for decades. While the data are important, just remember that large companies might have hundreds of insiders, which means that trying to determine a pattern can be difficult. Continue, as you normally would, to complete your due diligence on a company, but also be aware of what insiders are doing. They probably know more than the rest of us.

Article Sources
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