Insider Trading Explained

Jun 29, 2022

Written by:
John McDowell

What is insider trading?

Insider trading refers to trading in the stock of a publicly-traded company by its directors, employees, or anyone who has material, non-public information about its stock. Those who have insider information about the company can use it to take positions in the stock and earn profit from stock movement as the material and confidential information becomes public.

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What is considered insider trading?

Insider trading occurs when someone from within or outside the publicly-traded company obtains privileged unpublished material information and uses it to trade the company’s stock. However, insider trading can be legal as long as it complies with the rules and regulations set out by the SEC. For insider trading to be legal, the transactions conducted by the company’s directors or executives need to be timely submitted to the SEC and must also be reported on the company’s website.

Additionally, the law prohibits insiders from selling their holdings until six months from the date of the purchase, which effectively debars them from taking advantage of the undisclosed material information.

Why is insider trading illegal?

Insider trading is illegal because those with material and non-public information about a company in question can trade its stock to extract gains at the expense of other stockholders. Insiders, such as directors and top executives, usually have access to material information about the company, which they can use to gain an unfair advantage over normal retail traders or other institutions. For example, they can predict the impact of insider information on the stock’s direction when the material information is revealed to the public.

So, to provide a level-playing field to all players in the market, the SEC has declared it illegal for a company’s insiders, or anyone else, to trade stock based on privileged, unpublished material information to make a profit.

Who investigates insider trading?

The government has tasked the SEC with monitoring and investigating illegal insider trading. For this purpose, the SEC observes key events, such as mergers, acquisitions, earnings announcements, disclosure of material information, and any other significant event that can abruptly move the stock. If it suspects any malpractice concerning insider trading, it can investigate the matter and try the culprits under the SEC insider trading laws. The SEC also verifies complaints from traders and whistleblowers to determine the veracity and evidence of insider information.

Why is congress exempt from insider trading?

Insider trading that goes beyond the area of what the SEC allows is illegal for everybody, including lawmakers. The Stop Trading on Congressional Knowledge Act (STOCK Act) also confirms that members of congress are also subject to insider trading law. However, not a single member of congress has been put on trial for insider trading after 10 years since the passage of the bill. Insider trading is difficult to prove, particularly when members of congress have access to huge amounts of nonpublic, material information.

How to track insider trading?

Keeping track of the company's insiders' buying or selling activity can be beneficial for investors as it may offer valuable clues about the future direction of the stock. For example, if an executive or a director of a company buys the company's stock, it could signal the management's faith in the company or a sign that the stock is undervalued. Many investors track insider trading in stocks as part of their research, along with conducting fundamental analysis before investing in stocks.

To monitor insider trading in a stock, you can browse the SEC's Edgar database, which includes filings about buying and selling activities of the insiders. You can also get information about insider trading on many popular financial websites.

The SEC has made it mandatory for public limited companies, except for OTC (over-the-counter stocks), to report insider trading activities within two business days. For reporting these transactions, the SEC has three forms - Form-3, Form-4, and Form-5 - that companies need to file with the SEC. Form-3 is used for reporting transactions in the company's shares at initial ownership; Form-4 is used for reporting any changes in ownership of shares, and Form-5 is used for reporting any changes in share ownership that were not reported earlier in Form-4.

Which company's stock was associated with Martha Stewart's insider trading?

The SEC charged Martha Stewart, the CEO of Martha Stewart Living Omnimedia, for insider and other related offenses in 2003. She benefitted from insider information about a pharmaceutical company, ImClone Systems, and sold the shares before their imminent decline. The company formulated a cancer drug, Erbitux, which was disapproved by the Food and Drug Administration (FDA). While the shareholders of the company were optimistic about the drug approval as the growth of the company was tied to it, several of the company’s executives knew beforehand about the drug’s rejection and dumped the stock.

She sold around 4,000 shares of ImClone Systems after receiving non-public information from Merill Lynch’s broker, who was tipped by the company’s CEO, Samuel Waksal. She saved around $45,000 by offloading her holdings just before the stock fell. The drug rejection plummeted ImClone’s stock by 16% in a single day. She was tried and subsequently had to serve months in prison. Sam Waksal was awarded a seven-year sentence for his insider trading involvement in the same scandal.

Insider trading Summary

Insider trading has negative connotations attached to it, which is the reason why most people consider the practice of insider trading illegal. However, insiders can trade the company’s stocks provided that they don’t violate the insider trading rules and fulfill the disclosure and filing requirements set out by the SEC. Insider trading filings are mentioned on the SEC’s EDGAR database, which can give investors important clues about who is buying, selling, or diluting their stock.

Illegal insider trading can attract fines and even jail sentences. The SEC regularly monitors the stock market for any abnormal activity and is authorized to conduct investigations into insider trading. As an investor, it is essential for you to differentiate between legal and illegal insider trading.

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Tags: Basics of Stock Trading, Day Trading Terms

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