Education

Insider Trading Basics

What is Insider Trading?

When someone hears about insider trading, they generally assume it is about illegally taking advantage of confidential information. It is not surprising that insider trading has acquired such a negative reputation. Whenever the media reports on insider trading activities, it is almost always related to enforcement actions regarding illegal and unethical insider trading. Most people would be surprised to find out that the majority of insider trading is neither illegal nor unethical.

Insider trading is the trading of a public company's stock or securities by anyone with access to market moving nonpublic information about the company. This could be the CEO or other corporate officers, but may also include front line employees and contractors. Insider trading may also include trades by individuals who received stock tips from insiders with nonpublic information. It is the access to material nonpublic information that makes someone an insider.

Corporate officers and directors have significant access to market moving information that is not available to the public. However they buy and sell shares of their companies all the time. What makes this buying and selling illegal is the motivation behind their trades. It is illegal for insiders to profit from trades that are based on material information that is not in the public domain. If a corporate officer knows that an upcoming earnings report will greatly exceed analyst expectations, it would be illegal for them to profit from this information by buying stock in their company. Similarly if an insider knows of some upcoming bad news that is not available to the general public they would be prohibited from selling any shares they own until the news was publicly announced. Generally speaking, insiders are not permitted to profit from any corporate announcements before they are publicly available (Seyhun, 1998).

What information are insiders legally allowed to trade on? Insiders can and do trade on the basis of public information and their interpretation of what it means for their company’s stock price. For example if the price of their firm sharply declines and the insider knows of no reason based on the company’s fundamentals to justify the decline, they could profit by purchasing the undervalued stock (Seyhun, 1998). Insiders can also trade based on their judgment of the long term outlook for their firm. Insiders often have a high level of expertise and are highly informed on trends and developments in their industry. This expertise places them in a uniquely good position to judge whether the long term prospects are good or bad for their firm. There is nothing that legally prevents insiders from using their expertise to trade stock in their firms so long as their trading decisions are based on publicly available information.

Insider Trading Regulations and Compliance Restrictions

The Securities and Exchange Commission (SEC) is the primary federal agency responsible for enforcing insider trading laws. Insiders who are officers, directors, or shareholders owning 10% or more of a public company's stock are required to report trades they make in their company to the SEC. Reporting is required within 2 business days from when the trade was made, and becomes a public record once it has been reported to the SEC.

Under Section 16(b) of the Securities and Exchange Act, insiders are required to return all profits from buying and selling (or selling and buying) shares within a six month period (Jaffe, 1974). Insiders are not permitted to profit from short term trading in their firm over a time period of less than six months. This is called the short-swing profit restriction and exists to prevent insiders from manipulating upcoming corporate announcements to benefit themselves (Seyhun, 1998). Insiders are also prohibited from shorting stock in their companies. This helps keep the interests of insiders aligned with that of their shareholders.

In most large firms there are internal policies that govern the execution of insider trading. For example, an insider may be required to get permission from the compliance officer to buy or sell shares in order to ensure no regulations have been violated. Most firms also have explicitly defined blocks of time when insider buying and selling is allowed. These policies help to ensure that insiders can manage their portfolios without having to worry about whether or not they are violating the law (Seyhun, 1998).

Insider Trading Data

Insiders report their trades to the SEC using Forms 3, 4, and 5. Form 3 is used for initial filings. When an insider is reporting trades to the SEC for the first time they use Form 3. Changes in ownership are filed with Form 4. Any trades executed after the initial filing are reported using Form 4 and must be reported within 2 business days. Form 5 is used to report any transactions that should have been reported earlier using Form 4, or for any transactions that were eligible for deferred reporting. Insider Sleuth is primarily concerned with Form 4 transactions as these are the most relevant to understanding insider sentiment.

Once an insider has reported a trade to the SEC it becomes a public record. Records of insider trades can be searched on EDGAR at the SEC’s website along with any other public filings (10-K, 10-Q, etc…). For example the insider roster and most recent insider transactions for Apple can be found here. An example of a Form 4 can be found here. Information about recent insider trading activity can also be found at Yahoo Finance.

While the data found on EDGAR can be very useful when evaluating a firm, the data is highly unprocessed, and most of it will be irrelevant when trying to judge insider sentiment. For example shares not traded on the open market or not acquired at market prices are unlikely to be an indicator of an insider’s expectation of future stock returns. Similarly, shares received as part of an inheritance are unlikely to be helpful when evaluating a company. For these and various other reasons Insider Sleuth’s database includes only Form 4 transactions of common stock purchased on the open market. These are the transactions that are the most relevant when evaluating insider sentiment regarding any particular company or the market at large.

How Investors Can Use Insider Trading Data

Investors are told they should follow the smart money. Corporate insiders are the smartest money to be found when researching any specific company. Insiders have deeper knowledge of the operations and future prospects for their company than any outsider could hope to achieve (Lakonishok, Lee, 2001). When an insider trades on the open market they use their knowledge of developments in their own firm, their industry, and the economy at large and put their own money at risk. Thus insider transaction data can provide an independent forward looking indicator of sentiment for the smartest money around. Individual investors don't have access to the insights of corporate insiders. However, what insiders know can be inferred from their open market trading activity.

The famous investor Peter Lynch once said, "insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise." Nobody invests in the stock market for the purpose of losing money. In this regard insiders are no different than anybody else. When an insider purchases stock in their firm, it can generally be assumed it is because they believe the stock price will go up. Similarly an insider may sell shares because they believe their firm will under-perform the market. However, there are many other possible reasons for an insider to sell their stock other than the expected future price action. An insider may sell their stock in order to raise money to finance a large purchase such as a new home. They may sell stock in order to diversify their portfolio. Knowing this it is reasonable to assume that insider sales are generally less useful that insider purchases. Academic studies of insider trading have mostly supported this conclusion.

A lack of insider trading may also be an indicator of insider sentiment. For example if insiders suddenly stop purchasing shares in their firms this may be an indicator for poor future returns. On the other hand a decrease in insider selling make indicate that insiders believe the company’s stock price will increase in the near future. In his book The Vital Few versus The Trivial Many, George Muzea suggests that spotting divergences in insider behavior is the key to profiting by following insiders. In other words, interruptions in normal trading patterns are what is important for uncovering insider sentiment.

Because of the short-swing rule which prevents insiders from profiting from trades held for less than six months, insider trading data is probably most useful to investors looking to profit over a period of at least six months.

Studies on Insider Trading

There have been numerous studies which have sought to answer the question of whether insider trading data can be useful for outside investors. When reviewing these studies a consensus emerges for several points.

Studies have usually found that stock prices tend to rise following both insider purchases and insider sales. However stocks with net insider purchasing tend to outperform the market while stocks with net insider selling tend to under-perform the market. H. Nejat Seyhun, in his book Investment Intelligence from Insider Trading claims that stocks purchased by insiders outperformed a buy and hold strategy buy 4.5% over the next 12 months. Stocks sold by insiders under-performed the market portfolio by 2.7% over the next 12 months (Seyhun, 1998).

Insider selling has generally been found to be less informative than insider purchasing. Shorting stocks with high insider selling has not been found to be a viable trading strategy. Speculated reasons for this are that there are more possible motivations for insider selling than there are for insider purchasing. This makes it more difficult to separate the signal from the noise with insider selling data.

Studies have also shown that insider trading by smaller companies is more informative than it is for larger companies. This may be because any given piece of news is likely to have a smaller impact on the stock price of a large company than it would for a small company (Seyhun, 1998). Larger companies also tend to receive more analyst coverage as well as more attention by the market in general. Because of this shares in larger companies will tend to be priced more efficiently, and there will be less opportunity for out-sized gains by investors.

A study published in 2012 examined if better information could be derived from insider trading by monitoring only specific kinds of insiders. They divided insiders into 2 different groups called “routine traders” and “opportunistic traders”. Routine insiders were those whose trading followed a predictable schedule while opportunistic insider’s trading lacked this predictable schedule. Opportunistic insiders were shown to greatly outperform the routine insiders. The abnormal returns associated with routine insiders were essentially zero while the opportunistic insiders generated equal-weighted annualized abnormal returns of 21.6% (Cohen, Malloy, Pomorski, 2012).

Final Thoughts

Insider trading data shows great potential as a tool for investment analysis. There are however many challenges to its practical application. Insider Sleuth was created to help investors overcome some of these hurdles. Following insiders is not a guarantee of profits. Investors should view the insights from insider trading as an additional tool for a comprehensive investment strategy, not as a silver bullet for profits.

For further resources to learn more about insider trading and a list of academic studies refer to Insider Sleuth’s reference list.

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