UPDATED: April 2022
Legal Insider Trading: What Is It, and How It Affects Investors? – Most people assume that insider trading is always illegal. The term has been associated with scandals and names such as Enron, celebrity businesswoman Martha Stewart, and former Goldman Sachs director Rajat Gupta.
Legal Insider Trading: What Is It, and How It Affects Investors?
If you type “insider trading” in Google’s search box, the first hit is a definition from Google: “the illegal practice of trading on the stock exchange to one’s own advantage through having access to confidential information.” This is inaccurate at best because the term “insider trading” includes both legal and illegal conduct.
Illegal insider trading is considered an act of security fraud. The Securities Exchange Act of 1934 makes it clear that any person who purchases or sells a security while in possession of “material, non-public information” shall be held liable. This term applies to “corporate insiders,” such as managers, directors, or employees, as well as de-facto insiders who obtain material, private information from various sources. You could overhear some important news when dining at a restaurant, but trading on such information could potentially constitute illegal insider trading.
You can’t even ask your friends to profit from the information because “tipping” the information violates the law as well. Information is material if there is a substantial likelihood that it will affect a company’s stock price once released. In practice, it is usually difficult to prove how “material” information is. As such, illegal insider trading is very difficult to detect and prosecute.
The legal conduct of insider trading refers to trading by “corporate insiders.” A long list of people falls into this category, including directors, managers, employees, beneficial owners, and people affiliated with the firm in other significant ways. These people are allowed to trade securities of their firms, provided they do not possess material, non-public information.
Trades by corporate insiders must be filed with the U.S. Securities and Exchange Commission within two business days. Although these trades are not supposed to contain material information, many people believe that these trades reflect information that is not material enough to be released otherwise. Academic studies also find that insider trades can predict future stock returns and earnings.
Consistent with what people would expect, insider purchases seem to move stock prices more than insider sales do, and trades by managers and directors seem to move stock prices more than other traders do. Following insider trades, especially the large purchases by directors and managers, can be a lucrative trading strategy for sophisticated investors.
Should All Forms of Insider Trading Be Prohibited?
While many people might feel insider trading is not “fair” to outside investors, economists have long attempted to answer the question from the perspective of shareholder wealth and cost of capital. Empirical evidence so far suggests that illegal insider trading may have adverse effects on the general information environment and can thus increase a firm’s cost of capital and decrease a firm’s market value.
However, some researchers argue that legal insider trading could benefit shareholders by making stock prices more informative, which further lowers the cost of capital and increases firm value.
About the Author & How YOU Can Profit: This article is the copyrighted product of the team at BuybackAnalytics.com .
Buyback Analytics is a Top Tier Investing Platform to help investors find, analyze, and profit from investing opportunities not found through traditional investment tools. We specialize in this simple concept: Follow the trades of Insiders – CONSISTENTLY PROFITABLE Traders, Investors, and Institutions because THEY get Inside Information that YOU don’t:
LEGAL Insider Trading / Inside Traders (CEOs, CFOs, Corporation’s Accountants & Attorneys, Politicians, etc.)
Stock Buybacks (Share Repurchases) by Public Corporations (ie. Apple, Tesla, Netflix, Meta (Facebook), Microsoft, etc.)
Market Moving Institutions (Examples: Market Makers, Investment Banks, Stock Brokerages, Hedge Funds, etc.)
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