What Is Insider Trading?
An insideris a person who possesses either access to valuable non-public information about a corporation or ownership of stock equalingmore than 10% of a firm's equity. This makes a company's directors and high-level executives insiders.
Key Takeaways
- Aninsideris someone with either access to valuable non-public information about a corporation or ownership of stock equalingmore than 10% of a firm's equity.
- Insidersarelegally 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-publicmaterial information is generally used for profit.
- The SEC monitors illegal insider trading by looking attrading volumes, which increase when there is no news released by or about the company.
Understanding Insider Trading
Legal Insider Trading
Insidersarelegally permitted to buy and sell shares of the firm and any subsidiaries that employthem. 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-publicmaterial 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 informationis 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 ashort 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 itis 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.
FAQs
Insider trading is when non-published information from a company is used to make a trading decision by someone with an invested interest in that company. It is illegal to engage in insider trading, but it is legal to trade your company shares as long as you follow the guidelines set by the SEC.
Is insider trading always illegal? ›
Yes. Insider trading can be considered legal if corporate insiders (such as directors, executives, and employees) trade company stock without exploiting confidential material information. To do so, corporate insiders must file certain regulatory reports to the SEC and receive approval.
When did insider trading become illegal? ›
The SEC adopted a civil procedure in 1942, but the first time that insider trading was really identified as an offense was in the 1960s, and prosecutions didn't really take off until the advent of the hostile takeover in the 1980s, with investigators focusing on suspicious trading ahead of a merger or sale.
What makes trading illegal? ›
A person who becomes aware of non-public information and trades on that basis may be guilty of a crime. Trading by specific insiders, such as employees, is commonly permitted as long as it does not rely on material information not available to the general public.
Is it illegal to buy stock in a company you work for? ›
Insiders can (and do) buy and sell stock in their own company legally all of the time; their trading is restricted and deemed illegal only at certain times and under certain conditions. A common misconception is that only directors and upper management can be convicted of insider trading.
Is it insider trading if I bought Boeing puts? ›
Is it insider trading if I bought Boeing puts while inside the wrecked airplane? Hacker News. No, it is not. If you do not have a fiduciary relationship with Boeing and you have no confidentiality obligations with respect to the information, you are not trading on inside information.
How common is illegal insider trading? ›
Data drawn from all prosecuted insider trading cases
They estimate that insider trading occurs in one in five mergers and acquisition events and in one in 20 quarterly earnings announcements. These estimates imply that there is at least four times more actual insider trading than there are prosecution cases.
Why is it so hard to prove insider trading? ›
Direct evidence of insider trading is rare. There are no smoking guns or physical evidence that can be scientifically linked to a perpetrator. Unless the insider trader confesses his knowledge in some admissible form, evidence is almost entirely circ*mstantial.
What are some examples of insider trading? ›
Illegal Insider Trading
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.
How do people get caught for insider trading? ›
The Securities and Exchange Commission plays a pivotal role in detecting and prosecuting insider trading. The agency monitors trading activities and investigates unusual spikes in trading volume or price changes that precede significant corporate events, such as mergers or earnings reports.
A person is liable of insider trading when they have acted on such privileged knowledge in the attempt to make a profit. Sometimes it is easy to identify who insiders are: CEOs, executives and directors are of course directly exposed to material information before it's made public.
What are the three types of insider trading? ›
Classic Insider Trading: Buying or selling assets based on important non-public information. Tipper-Tippee Trading: An insider gives others access to confidential information so they can trade using it. Trading During Blackout Periods: Insider trading during times when particular people are barred from trading.
What is the punishment for insider trading? ›
According to the SEC in the US, a conviction for insider trading may lead to a maximum fine of $5 million and up to 20 years of imprisonment.
What is the 10 am rule in stock trading? ›
Some traders follow something called the "10 a.m. rule." The stock market opens for trading at 9:30 a.m., and the time between 9:30 a.m. and 10 a.m. often has significant trading volume. Traders that follow the 10 a.m. rule think a stock's price trajectory is relatively set for the day by the end of that half-hour.
What is insider trading in simple words? ›
It means buying and selling of securities by those persons (directors, promoters, etc), who have some secret information about the company and who wish to take advantage of such secret information.
Why do people commit insider trading? ›
That's what insider trading is all about. Insider trading refers to using non-public information to make investment decisions. This means that people with access to important information that the general public doesn't have are using it to make a profit.
How often is insider trading prosecuted? ›
For example, the US Securities and Exchange Commission (SEC) prosecutes approximately 50 insider trading cases per year (SEC, 2015).
How hard is it to prove insider trading? ›
Insider trading is an extraordinarily difficult crime to prove. The underlying act of buying or selling securities is, of course, perfectly legal activity. It is only what is in the mind of the trader that can make this legal activity a prohibited act of insider trading. Direct evidence of insider trading is rare.
Why is insider trading so hard to prove? ›
This prosecutorial choice may have been due to how the law is written. “It is incredibly difficult to prove an insider trading case,” said Daniel Taylor, a forensic accounting professor at the University of Pennsylvania. “Congress has never actually defined what insider trading was and explicitly outlawed it.”
