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What Is Insider Trading?
An insider is a person who possesses either access to valuable non-public information about a corporation or ownership of stock equaling more than 10% of a firm’s equity. This makes a company’s directors and high-level executives insiders.
Top 3 Most Scandalous Insider Trading Debacles
Key Takeaways
- An insider is someone with either access to valuable non-public information about a corporation or ownership of stock equaling more than 10% of a firm’s equity.
- Insiders are legally permitted to buy and sell shares, but the transactions must be registered with the SEC.
- Legal insider trading happens often, such as when a CEO buys back company shares, or when employees buy stock in the company where they work.
- Illegal use of non-public material information is generally used for profit.
- The SEC monitors illegal insider trading by looking at trading volumes, which increase when there is no news released by or about the company.
Understanding Insider Trading
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. Often, 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 their 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.
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.
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 the vice president of a technology company’s engineering department 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 their friend owns shares of the company and warns the friend to sell their 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 their shares and shorts 1,000 shares of the stock before the earnings are released. Now it is illegal insider trading. However, if they trade the security after the earnings are released, it is not considered illegal because they do not have a direct advantage over other traders or investors.