In the 1980s, Ivan Boesky was one of the most well-known arbitrageurs in the market, with an uncanny ability to pick out potential takeover targets and invest before an offer was made. Sometimes, his purchases would come just days before an unsolicited bid was made public. After raking in hundreds of millions of dollars, regulators eventually discovered that his precognition turned out to be fraudulent.

The term "insider trading" is often associated with people like Ivan Boesky, but insider trading also refers to perfectly legal buying or selling of stock, by executives, board members, major holders and other investors, privileged with information in a company's stock. While not quite as profitable as Boesky's scheme, monitoring these trades has proven useful in making investment decisions. Or has it?

Insider Trading's Proven Success
Insider trading, of the legal variety, is a topic that has been extensively studied by Wall Street scholars. After all, the ability to consistently beat the market, over time, can be worth a lot of money to hedge funds and other large investors. Since such trades were recorded, several studies found that insiders were indeed better informed and earn abnormal returns of up to 30%, in some cases.

Additional studies found that non-insiders, or regular investors, could also earn similar significant abnormal profits, by imitating insiders. That is, they could purchase stock following the insiders' purchases and sell after the insiders' sales, using publicly available insider trading information. From these studies sprang a cottage industry of insider trading information providers, that still exists today. 

Regulators Pull the Plug on the Party
The aforementioned studies found that insiders tend to be contrarian investors that purchase stock after significant price declines, such as over-reactions to a bad earnings report. Unfortunately, these tendencies to trade and profit around earnings time, was what prompted regulators to take action to curb the market abnormalities, through Sarbanes-Oxley (SOX) and Regulation Fair Disclosure (RegFD). (To know more about SOX, check out: How The Sarbanes-Oxley Era Affected IPOs.)

In 2011, Inmoo Lee, Michael Lemmon, Yan Li and John Sequeira published a paper called "The Effects of Regulation on the Volume, Timing, and Profitability of Insider Trading." It is found the overall informativeness of insider trading has decreased over time and the profitability of insider trading completely disappeared after 2002, when regulations were introduced.

A Silver Lining for Savvy Investors
Investors may no longer be able to profit from copying insider transactions, but they can still provide a number of clues to support a larger investment thesis. For instance, in 2005, Arturo Bris found that insider trading enforcement actually increases the profitability of insider trading around takeover transactions. This means that insiders can still profit from non-earnings related events.

Keeping this in mind, here are a few tips for this new era of insider trading:

  • Finding the Right Buying. Insider transactions occur in a number of different ways, but the most telling are "P" transactions that signify cash purchases of stock.
  • Look for Clusters of Buying. Insider trades that occur in clusters and involve executives, are more reliable indicators than small one-off purchases by directors or major holders.
  • Pair It with a Thesis. Investors should try and pair insider trading activity with an overall thesis, such as a case for a buyout or earnings improvement.
  • Use It as a Starting Point. Investors can also use clusters of insider trading as a starting point for further research into why those insiders may be purchasing stock.

The Tools of the Trade
Tracking insiders can be a daunting task, without the right tools. Searching through Form 4 filings in the SEC's EDGAR database is certainly one way to go about it, but there are many tools on the market today to make life easier. These online services, both free and paid, parse a multitude of insider trading transactions, determine the value of the transactions, and provide an easy-to-use interface.

Here are a few of the most popular platforms:

  • Form4Oracle - Form4Oracle is one of the most comprehensive platforms for tracking insider trades, with the ability to breakdown transactions by type and view past insider performance.
  • SECForm4 - SECForm4 is one of the oldest providers of insider trading tools, with a number of free and paid options, including the ability to generate graphs to visualize insider trading trends.
  • InsiderScore - InsiderScore is one of the most popular solutions for institutional investors to track not only insider trading, but also hedge funds and other parties.

The Bottom Line
Insider trading was a very profitable activity, in the past, that produced consistent abnormal returns for both insiders and their outside followers. The profitability of insider trading has decreased over time and may have been mostly eliminated after Sarbanes-Oxley and Regulation FD went into effect. Despite the regulations there are still several ways in which insider trading can be useful for individual and institutional investors looking to profit. Using tools like Form4Oracle, SECForm4 and InsiderScore, investors can quickly and easily find insider trading information to help them support their larger investment thesis.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.