Differences between legal and illegal insider trading
Securities regulators around the world restrict trading of public companies based on inside information. The reason is simple: Corporate insiders -- usually defined as chief executives, directors and large shareholders -- often have access to information about their companies that are unavailable to other investors. This nonpublic information could be used for personal profits at the expense of shareholders. Because fair markets are important to public confidence in securities markets, governments strive to ensure markets are seen as fair by investors. Nothing erodes confidence in financial markets more than when traders feel markets are rigged in favor of insiders.
However, while all countries have insider trading rules, that doesn’t prevent some insiders from trading based on insights unique to the insider. In fact, insider trading rules are complex and differ from country to country. Enforcement also differs between countries. There is lots of grey surrounding what’s legal and what isn’t. Indeed, insiders are rarely charged and convicted for insider trading violations. Regulators typically go after only the most egregious cases, making dramatic convictions in the hope of deterring illicit transactions.
Regulators require corporate insiders who transact in their own company’s stock to publicly disclose those trades. In the U.S., insiders must file Form 4 reports with the SEC within 2 days of a transaction in their company’s shares. These trades can be viewed at the SEC’s Edgar website or at various services that follow insider trading.
But when you view a trade disclosed by an insider, there’s always the question:
- Does the executive know something no one else does?
- Is the insider trading on nonpublic information?
- Or is the insider’s trading simply informed by his or her superior expertise and experience?
From your point of view as an investor, this is a moot point. All that really matters is this: Certain trades disclosed by certain insiders tend to predict future moves in the underlying stock.
Focus on insider buying -- insider selling is typically not predictive
So which vital few insider trades among the thousands disclosed should an investor pay attention to?
When it comes to following insider trades, you want to copy trades that truly reflect an opinion by the insider on his company’s stock. If a CEO is selling shares in his company, does that reflect his a negative viewpoint on his company’s prospects, or is he just raising some cash? Likewise, if you see insider buying by a CEO, does that mean he’s bullish on his company’s shares or is he just buying a little to make himself look supportive?
As a rule, insider buying is significantly more predictive than insider selling. Insiders sell shares for any number of reasons: Because they received options as part of their compensation; because they need money to buy a house; because they need to pay college tuition for the children, or because they must pay for a divorce settlement. It’s also common for executives who have most of their wealth tied up in their own company’s shares to sell simply to diversify.
But there is generally only one reason an insider buys stock on the open market -- because he or she thinks the price of the company is going higher.
The most compelling insider buys to follow are those that reflect extreme bullishness -- even greed -- by the insider. You want to follow the insider into his stock when he is adding significant “skin in the game”. Insiders know their companies better than anyone, and when they place big bets on their shares, you want to join them in the trade.