An "insider" is a person who possesses either access to valuable non-public information about a corporation (this makes a company's directors and high-level executives insiders) or ownership of stock equaling 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.
Legal Insider Trading
Insiders are legally permitted to buy and sell shares of the firm—and any subsidiaries—that employ them. 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.
Legal insider trading happens often, such as when a CEO buys back shares of their company, or when other employees purchase stock in the company in which they work. Oftentimes, a CEO purchasing shares can influence the price movement of the stock they own. A good example is whenever Warren Buffett purchases, or sells, shares in the companies under the Berkshire Hathaway umbrella.
Illegal Insider Trading
The more infamous form of insider trading is the illegal use of non-public material information for profit. It's important to remember 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.
Top 3 Most Scandalous Insider Trading Debacles
Insider Trading vs. Insider Information
Insider information is knowledge of material related to a publicly traded company that provides an unfair advantage to the trader or investor. For example, say a vice president of the engineering department of a technology company overhears a meeting between the CEO and the CFO.
Two weeks before the company releases its earnings, the CFO discloses to the CEO that the company did not meet its sales expectations and lost money over the past quarter. The vice president of the engineering department knows her friend owns shares of the company and warns her friend to sell her shares right away and look to open a short position. This is an example of insider information because earnings have not been released to the public.
Suppose the vice president's friend then sells her shares and shorts 1,000 shares of the stock before the earnings are released. Now it is illegal insider trading. However, if she trades the security after the earnings are released, it is not considered illegal because she does not have a direct advantage over other traders or investors.