It may seem that corporate executives always have the right timing when it comes to buying and selling, however this is not by chance. Considering that they have access to virtually all data they need on a company, this is not a surprise either. On the other hand, individual investors also have a few tools they can put to use. This article will inform you about insider trading; what it is, where to find it, and how it will help an individual investor.
Insider Trading: What is it?
Insider trading can be done both legally and illegally. The latter is not difficult to define. The trading of the security of an item or material that is not yet public is deemed an illegal trade. The insiders who are involved in this action violate their fiduciary duty. This is something anyone who is involved with a company should avoid at all costs.
A widely believed myth is that only the upper management and the directors can be prosecuted for insider trading. This is not true because anyone who has materials or information that is not public can commit the act as well. That is why anyone can be considered an insider, even family and friends.
Below are some illegal insider trading examples:
? A company’s CEO sells stocks after learning that his company will be losing an important government contract in the coming month.
? A company’s CEO’s son decides to sell the company’s stocks after discovering the news about the big government contract from his dad.
? An official from the government also learns about the government contract that the company will lose and sells the stocks.
Strict measures are taken by the Securities and Exchange Commission (SEC) against those who make unfair trades and undermine the confidence and integrity of investors and financial markets respectively. Even an individual who “tips” someone else with nonpublic insider information can face the consequences. The Dirks Test is something used by the SEC to determine if an insider gave an illegal tip. According to the test, the tipster will be help liable if he or she breaches the trust of his of her company with full understanding that it was a breach.
Insider Trading: The Legal Way
As you have probably been suspected by now, there must be a way to go about insider trading without violating laws. As a matter of fact, the practice is very common between companies. The restrictions to insider trading only apply in certain circumstances.
In the eyes of the SEC, an insider is any member of a company that owns or controls 10% or more of the company. A Form 14a is the document which holds the records of all the officers and directors of a company as well as the share interest they own. Such individuals are asked to report any transactions within two days of the date that the inside trade was made. Reported changes in the holdings of the insiders are sent electronically to the SEC. This is done as a Form 4 that details all the insider loans and trades of a company.
This is the kind of information individual investors can use to make well informed choices. This can be illustrated in the example of insiders buying shares in their own company. This is usually a sign that there is something that normal investors do not know that they should. It could be that they believe their stocks can gain more value or there may be major changes coming ahead that will boost the share values. Peter Lynch, one of the best investors ever known, noted that there are many reasons for insiders to sell shares, but there is only one reason for them to buy. That is, they think the value of the bought shares are soon to rise. Since insiders cannot buy and sell stocks within any period of six months, they only buy stocks when they have data that suggest a long term performance of the company.
A renowned professor (Nejat Seyhun) at the University of Michigan noticed interesting patterns in insider trading. When executives in a company bought shares in that company, they saw a 8.9% higher performance on the market over the following twelve months. When stocks were sold, they performed 5.4% lower. His book, “Investment Intelligence from Insider Trading”, can teach you more about the trade.
You can also find insider-trading data at Yahoo! Finance and SEC EDGAR Database. Insider trading is not something new and has been done for years. The inside data is readily available to anyone who looks for it. Keep the insider trading patterns in mind when making your decisions, because the chances are they reflect decisions based on more exclusive data.