Insider trading is the trading of a corporation's stock or other securities (e.g. bonds or stock options) by individuals with potential access to non-public information about the company. In most countries, trading by corporate insiders such as officers, key employees, directors, and large shareholders may be legal, if this trading is done in a way that does not take advantage of non-public information. However, the term is frequently used to refer to a practice in which an insider or a related party trades based on material non-public information obtained during the performance of the insider's duties at the corporation, or otherwise in breach of a fiduciary or other relationship of trust and confidence or where the non-public information was misappropriated from the company.[1]

In the United States and several other jurisdictions, trading conducted by corporate officers, key employees, directors, or significant shareholders (in the U.S., defined as beneficial owners of ten percent or more of the firm's equity securities) must be reported to the regulator or publicly disclosed, usually within a few business days of the trade. Many investors follow the summaries of these insider trades in the hope that mimicking these trades will be profitable. While "legal" insider trading cannot be based on material non-public information, some investors believe corporate insiders nonetheless may have better insights into the health of a corporation (broadly speaking) and that their trades otherwise convey important information (e.g., about the pending retirement of an important officer selling shares, greater commitment to the corporation by officers purchasing shares, etc.)

Illegal insider trading is believed to raise the cost of capital for securities issuers, thus decreasing overall economic growth. [2]

Legal insider trading

Legal trades by insiders are common, as employees of publicly-traded corporations often have stock or stock options. These trades are made public in the US through SEC filings, mainly Form 4. Prior to 2001, US law restricted trading such that insiders mainly traded during windows when their inside information was public, such as soon after earnings releases.[3] SEC Rule 10b5-1 clarified that the U.S. prohibition against insider trading does not require proof that an insider actually used material nonpublic information when conducting a trade; possession of such information alone is sufficient to violate the provision, and the SEC would impute an insider in possession of material nonpublic information uses this information when conducting a trade. However, Rule 10b5-1 also created for

insiders an affirmative defense if the insider can demonstrate that the trades conducted on behalf of the insider were conducted as part of a preexisting contractor written, binding plan for trading in the future.[3] For example, if a corporate insider plans on retiring after a period of time and, as part of his or her retirement planning, adopts a written, binding plan to sell a specific amount of the company's stock every month for the next two years, and during this period the insider comes into possession of material nonpublic information about the company, any subsequent trades based on the original plan might not constitute prohibited insider trading.

[edit]Illegal insider trading

Rules against insider trading on material non-public information exist in most jurisdictions around the world, though the details and the efforts to enforce them vary considerably. The United States is generally viewed as having the strictest laws against illegal insider trading, and makes the most serious efforts to enforce them.[4]

[edit]Definition of "insider"

In the United States and Germany, for mandatory reporting purposes, corporate insiders are defined as a company's officers, directors and any beneficial owners of more than ten percent of a class of the company's equity securities. Trades made by these types of insiders in the company's own stock, based on material non-public information, are considered to be fraudulent since the insiders are violating the fiduciary duty that they owe to the shareholders. The corporate insider, simply by accepting employment, has undertaken a legal obligation to the shareholders to put the shareholders' interests before their own, in matters related to the corporation. When the insider buys or sells based upon company owned information, he is violating his obligation to the shareholders.

For example, illegal insider trading would occur if the chief executive officer of Company A learned (prior to a public announcement) that Company A will be taken over, and bought shares in Company A knowing that the share price would likely rise.

In the United States and many other jurisdictions, however, "insiders" are not just limited to corporate officials and major shareholders where illegal insider trading is concerned, but can include any individual who trades shares based on material non-public information in violation of some duty of trust. This duty may be

imputed; for example, in many jurisdictions, in cases of where a corporate insider "tips" a friend about non-public information likely to have an effect on the company's share price, the duty the corporate insider owes the company is now imputed to the friend and the friend violates a duty to the company if he or she trades on the basis of this information.

[edit]Liability for insider trading

Liability for insider trading violations cannot be avoided by passing on the information in an "I scratch your back, you scratch mine" or quid pro quo arrangement, as long as the person receiving the information knew or should have known that the information was company property.

For example, if Company A's CEO did not trade on the undisclosed takeover news, but instead passed the information on to his brother-in-law who traded on it, illegal insider trading would still have occurred.[5]

[edit]Misappropriation theory

A newer view of insider trading, the "misappropriation theory" is now part of US law. It states that anyone who misappropriates (steals) information from their employer and trades on that information inany stock (not just the employer's stock) is guilty of insider trading.

For example, if a journalist who worked for Company B learned about the takeover of Company A while performing his work duties, and bought stock in Company A, illegal insider trading might still have occurred. Even though the journalist did not violate a fiduciary duty to Company A's shareholders, he might have violated a fiduciary duty to Company B's shareholders (assuming the newspaper had a policy of not allowing reporters to trade on stories they were covering).[6]

[edit]Proof of responsibility

Proving that someone has been responsible for a trade can be difficult, because traders may try to hide behind nominees, offshore companies, and other proxies. Nevertheless, the U.S. Securities and Exchange Commission prosecutes over 50 cases each year, with many being settled administratively out of court. The SEC and several stock exchanges actively monitor trading, looking for suspicious activity.

[edit]Trading on information in general

Not all trading on information is illegal inside trading, however. For example, while dining at a restaurant, you hear the CEO of Company A at the next table telling the CFO that the company's profits will be higher than expected, and then you buy the stock, you are not guilty of insider trading unless there was some closer connection between you, the company, or the company officers. However, information about a tender offer (usually regarding a merger or acquisition) is held to a higher standard. If this type of information is obtained (directly or indirectly) and there is reason to believe it is non-public, there is a duty to disclose it or abstain from trading.[7]

[edit]Tracking insider trades

Since insiders are required to report their trades, others often track these traders, and there is a school of investing which follows the lead of insiders. This is of course subject to the risk that an insider is making a buy specifically to increase investor confidence, or making a sell for reasons unrelated to the health of the company (e.g. a desire to diversify or pay a personal expense).

As of December 2005 companies are required to announce times to their employees as to when they can safely trade without being accused of trading on inside information.

[edit]American insider trading law

The United States has been the leading country in prohibiting insider trading made on the basis of material non-public information. Thomas Newkirk and Melissa Robertson of the U.S. Securities and Exchange Commission (SEC) summarize the development of U.S. insider trading laws.[8] Insider trading has a base offense level of 8, which puts it in Zone A under the U.S. Sentencing Guidelines. This means that first-time offenders are eligible to receive probation rather than incarceration.[9]

[edit]Common law

U.S. insider trading prohibitions are based on English and American common law prohibitions against fraud. In 1909, well before the Securities Exchange Act was passed, the United States Supreme Court ruled that a corporate director who bought that company’s stock when he knew it was about to jump up in price committed fraud by buying while not disclosing his inside information.

Section 17 of the Securities Act of 1933 [10]  contained prohibitions of fraud in the sale of securities which were greatly strengthened by the Securities Exchange Act of 1934.[11]

Section 16(b) of the Securities Exchange Act of 1934 prohibits short-swing profits (from any purchases and sales within any six month period) made by corporate directors, officers, or stockholders owning more than 10% of a firm’s shares. Under Section 10(b) of the 1934 Act, SEC Rule 10b-5, prohibits fraud related to securities trading.

The Insider Trading Sanctions Act of 1984 and the Insider Trading and Securities Fraud Enforcement Act of 1988 provide for penalties for illegal insider trading to be as high as three times the profit gained or the loss avoided from the illegal trading.[12]

[edit]SEC regulations

SEC regulation FD ("Fair Disclosure") requires that if a company intentionally discloses material non-public information to one person, it must simultaneously disclose that information to the public at large. In the case of an unintentional disclosure of material non-public information to one person, the company must make a public disclosure "promptly."[13]

Insider trading, or similar practices, are also regulated by the SEC under its rules on takeovers and tender offers under the Williams Act.

[edit]Court decisions

Much of the development of insider trading law has resulted from court decisions.

In SEC v. Texas Gulf Sulphur Co. (1966), a federal circuit court stated that anyone in possession of inside information must either disclose the information or refrain from trading.[14]

In 1909, the Supreme Court of the United States ruled in Strong v. Repide that a director upon whose action the value of the shares depends cannot avail of his knowledge of what his own action will be to acquire shares from those whom he intentionally keeps in ignorance of his expected action and the resulting value of the shares. Even though in general, ordinary relations between directors and shareholders in a business corporation are not of such a fiduciary nature as to make it the duty of a director to disclose to a shareholder the general knowledge which he may possess regarding the value of the shares of the company before he

purchases any from a shareholder, yet there are cases where, by reason of the special facts, such duty exists.

In 1984, the Supreme Court of the United States ruled in the case of Dirks v. SEC that tippees (receivers of second-hand information) are liable if they had reason to believe that the tipper had breached a fiduciary duty in disclosing confidential information and the tipper received any personal benefit from the disclosure. (Since Dirks disclosed the information in order to expose a fraud, rather than for personal gain, nobody was liable for insider trading violations in his case.)

The Dirks case also defined the concept of "constructive insiders," who are lawyers, investment bankers and others who receive confidential information from a corporation while providing services to the corporation. Constructive insiders are also liable for insider trading violations if the corporation expects the information to remain confidential, since they acquire the fiduciary duties of the true insider.

In United States v. Carpenter (1986) the U.S. Supreme Court cited an earlier ruling while unanimously upholding mail and wire fraud convictions for a defendant who received his information from a journalist rather than from the company itself. The journalist R. Foster Winans was also convicted, on the grounds that he had misappropriated information belonging to his employer, the Wall Street Journal. In that widely publicized case, Winans traded in advance of "Heard on the Street" columns appearing in the Journal.[15]

The court ruled in Carpenter: "It is well established, as a general proposition, that a person who acquires special knowledge or information by virtue of a confidential or fiduciary relationship with another is not free to exploit that knowledge or information for his own personal benefit but must account to his principle for any profits derived therefrom."

However, in upholding the securities fraud (insider trading) convictions, the justices were evenly split.

In 1997 the U.S. Supreme Court adopted the misappropriation theory of insider trading in United States v. O'Hagan, 521 U.S. 642, 655 (1997). O'Hagan was a partner in a law firm representing Grand Metropolitan, while it was considering a tender offer for Pillsbury Co. O'Hagan used this inside information by buying call options on Pillsbury stock, resulting in profits of over $4 million. O'Hagan claimed that neither he nor his firm owed a fiduciary duty to Pillsbury, so that he did not commit fraud by purchasing Pillsbury options.[16]

The Court rejected O'Hagan's arguments and upheld his conviction.

The "misappropriation theory" holds that a person commits fraud "in connection with" a securities transaction, and thereby violates 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. Under this theory, a fiduciary's undisclosed, self-serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of the information. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company's stock, the misappropriation theory premises liability on a fiduciary-turned-trader's deception of those who entrusted him with access to confidential information.

The Court specifically recognized that a corporation’s information is its property: "A company's confidential information...qualifies as property to which the company has a right of exclusive use. The undisclosed misappropriation of such information in violation of a fiduciary duty...constitutes fraud akin to embezzlement – the fraudulent appropriation to one's own use of the money or goods entrusted to one's care by another."

In 2000, the SEC enacted Rule 10b5-1, which defined trading "on the basis of" inside information as any time a person trades while aware of material nonpublic information – so that it is no defense for one to say that she would have made the trade anyway. This rule also created an affirmative defense for pre-planned trades.

[edit]Security analysis and insider trading

Security analysts gather and compile information, talk to corporate officers and other insiders, and issue recommendations to traders. Thus their activities may easily cross legal lines if they are not especially careful. The CFA Institute in its code of ethics states that analysts should make every effort to make all reports available to all the broker's clients on a timely basis. Analysts should never report material nonpublic information, except in an effort to make that information available to the general public. Nevertheless, analysts' reports may contain a variety of information that is "pieced together" without violating insider trading laws, under the mosaic theory.[17] This information may include non-material nonpublic information as well as material public information, which may increase in value when properly compiled and documented.

In May 2007, a bill entitled the "Stop Trading on Congressional Knowledge Act, or STOCK Act" was introduced that would hold congressional and federal employees liable for stock trades they made using information they gained through their jobs and also regulate analysts or "Political Intelligence" firms that research government activities.[18] The bill has not passed.[19]

[edit]Arguments for legalizing insider trading

Some economists and legal scholars (e.g. Henry Manne, Milton Friedman, Thomas Sowell, Daniel Fischel, Frank H. Easterbrook) argue that laws making insider trading illegal should be revoked. They claim that insider trading based on material nonpublic information benefits investors, in general, by more quickly introducing new information into the market. [20]

Milton Friedman, laureate of the Nobel Memorial Prize in Economics, said: "You want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that." Friedman did not believe that the trader should be required to make his trade known to the public, because the buying or selling pressure itself is information for the market.[21]

Other critics argue that insider trading is a victimless act: A willing buyer and a willing seller agree to trade property which the seller rightfully owns, with no prior contract (according to this view) having been made between the parties to refrain from trading if there is asymmetric information.

Legalization advocates also question why "trading" where one party has more information than the other is legal in other markets, such as real estate, but not in the stock market. For example, if ageologist knows there is a high likelihood of the discovery of petroleum under Farmer Smith's land, he may be entitled to make Smith an offer for the land, and buy it, without first telling Farmer Smith of the geological data.[14] Nevertheless, circumstances can occur when the geologist would be committing fraud if, because he owes a duty to the farmer, he did not disclose the information; e.g., if he had been hired by Farmer Smith to assess the geology of the farm.

Advocates of legalization make free speech arguments. Punishment for communicating about a development pertinent to the next day's stock price might seem to be an act of censorship.[22] If the information being conveyed is proprietary

information and the corporate insider has contracted to not expose it, he has no more right to communicate it than he would to tell others about the company's confidential new product designs, formulas, or bank account passwords.

There are very limited laws against "insider trading" in the commodities markets, if, for no other reason, than that the concept of an "insider" is not immediately analogous to commodities themselves (e.g., corn, wheat, steel, etc.). However, analogous activities such as front running are illegal under U.S. commodity and futures trading laws. For example, a commodity broker can be charged with fraud if he or she receives a large purchase order from a client (one likely to affect the price of that commodity) and then purchases that commodity before executing the client's order in order to benefit from the anticipated price increase.

[edit]Legal differences among jurisdictions

The US and the UK vary in the way the law is interpreted and applied with regard to insider trading.

In the UK, the relevant laws are the Criminal Justice Act 1993 Part V Schedule 1 and the Financial Services and Markets Act 2000, which defines an offence of Market Abuse.[23] It is also illegal to fail to trade based on inside information (whereas without the inside information the trade would have taken place). The principle is that it is illegal to trade on the basis of market-sensitive information that is not generally known. No relationship to the issuer of the security is required; all that is required is that the party guilty traded (or caused trading) whilst having inside information.

Japan enacted its first law against insider trading in 1988. Roderick Seeman says: "Even today many Japanese do not understand why this is illegal. Indeed, previously it was regarded as common sense to make a profit from your knowledge."[24]

In accordance with EU Directives, Malta enacted the Financial Markets Abuse Act in 2002, which effectively replaced the Insider Dealing and Market Abuse Act of 1994.

The "Objectives and Principles of Securities Regulation"[25] published by the International Organization of Securities Commissions (IOSCO) in 1998 and updated in 2003 states that the three objectives of good securities market regulation are (1) investor protection, (2) ensuring that markets are fair, efficient and

transparent, and (3) reducing systemic risk. The discussion of these "Core Principles" state that "investor protection" in this context means "Investors should be protected from misleading, manipulative or fraudulent practices, including insider trading, front running or trading ahead of customers and the misuse of client assets." More than 85 percent of the world's securities and commodities market regulators are members of IOSCO and have signed on to these Core Principles.

The World Bank and International Monetary Fund now use the IOSCO Core Principles in reviewing the financial health of different country's regulatory systems as part of these organization's financial sector assessment program, so laws against insider trading based on non-public information are now expected by the international community. Enforcement of insider trading laws varies widely from country to country, but the vast majority of jurisdictions now outlaw the practice, at least in principle.

Larry Harris claims that differences in the effectiveness with which countries restrict insider trading help to explain the differences in executive compensation among those countries. The U.S., for example, has much higher CEO salaries than do Japan or Germany, where insider trading is less effectively restrained.[26]

Insider TradingThe illegal kind of Insider Trading is the trading in a security (buying or selling a stock) based on material information that is not available to the general public. It is prohibited by the US Securities and Exchange Commission (SEC) because it is unfair and would destroy the securities markets by destroying investor confidence.

An InsiderA company insider is someone who has access to the important information about a company that affects its stock price or might influence investors decisions. This is called material information.

The company executives obviously have material information. The Vice President of Sales, for example, knows how much the company has sold and whether it will meet the estimates it has provided to investors. Others within the company also have material information. The accountant who prepares the sales forecast

spreadsheet and the administrative assistant who types up the press release also are insiders.

A public company, if it is smart, limits the number of people who have access to material information and, therefore, are considered insiders. This is done for a couple of reasons. First, they want to limit the likelihood that anyone will "leak" the information. Second, being an insider means being subject to severe limits on when you can trade in the company stock, usually only the middle month of each quarter.

The company's senior management are insiders. So are some of the financial analysts. The top sales people usually also are insiders, although a regional sales manager who only sees his or her own region's results may not be one. The individuals in Investor Relations and/or Public Relations who prepare the public announcements also are insiders.

If the company is developing a new product that could be a big seller, the key people in the Research & Development team would also be considered insiders, provided the information they have is material, as defined above.

Other individuals who are not employees, but with whom the company needs to share material information, are also insiders. This list could include brokers, bankers, lawyers, etc.

Not An InsiderSo does that mean you are not an insider unless you are on the company's management team, financial or development teams, or someone hired to handle the material information? In a word, "No".

The SEC includes in its definition of insiders those who have "temporary" or "constructive" access to the material information. If the President of a company tells you that the company's best hope for a breakthrough product isn't going to get regulatory approval, you are now every bit as much an insider as he is, with respect to that information. It is illegal for him to trade based on that knowledge before it becomes public knowledge. It is equally illegal for you to do so because you are now a "temporary insider". This remains true regardless of how many times the information is passed. If the president tells his barber, who tells her baby sitter, who tells her doctor, who tells you, the barber, baby sitter, doctor and you are all "temporary insiders".

Anyone who has material information is prohibited from trading, based on that knowledge, until the information is available to the general public. The US Supreme Court ruled recently, that this even applies to someone with no ties to the company. Possession of material information makes you an insider, even if you stole the information.

Significant PenaltiesSections 10(b) and 14(e) of the Securities Exchange Act of 1934 give the SEC the authority to seek a court order requiring violators to give back their trading profits. The SEC can also ask the court to impose a penalty of up to three times the profit the violators realized from their insider trading.

In addition to the financial penalties, there are criminal penalties. Many now feel those penalties are not strong enough and are working to increase them substantially. A bill in the US Senate, for instance, seeks to make defrauding shareholders a felony punishable by up to 10 years in prison.

Manage This IssuePolice your insiders yourself. Don't allow insider trading. Don't engage in it yourself. It is in your company's best interest to prevent insider trading so you don't have the SEC investigating you. Even if the company and all its officers eventually are cleared by the SEC of any wrong doing, the investigation itself can have lasting detrimental effects on the company.

Don't share material information with anyone who is not an insider. Make sure all insiders understand the responsibility this places on them. Make sure everyone in the company understands the circumstances under which they might become "temporary insiders' and how they must treat that situation.

he Definition of Insider Trading

Insider trading occurs when someone makes an investment decision based on information that is not available to the general public. In some cases, the information allows them to profit, in others, avoid a loss. (In the Martha Stewart - ImClone scandal, the latter happened to be the case.)

Insider trading was not considered illegal at the beginning of the twentieth century; in fact, a Supreme Court ruling once called it a “perk” of being an executive. After the excesses of the 1920’s, the subsequent decade of depression, and the resulting shift in public opinion, it was banned, with serious penalties being imposed on those who engaged in the practice.

The Penalties for Insider Trading

Depending upon the severity of the case, insider trading penalties generally consist of a monetary penalty and jail time. In recent years, the Securities and Exchange Commission (SEC) has moved to ban insider trading violators from serving as an executive at any publicly traded company.

What Constitutes Criminal Insider Trading

Just what constitutes insider trading? The question is much trickier than it seems. In order for the SEC to prosecute someone for insider trading, they must prove that the defendant had a “fiduciary duty” to the company and / or intended to personally gain from buying or selling shares based upon the insider information. This test of duty, however, was significantly weakened by the Supreme Court'sUnited States vs. O'Hagan ruling. In 1988, James O'Hagan was a lawyer at the firm of Dorsey & Whitney. After the firm began representing Grand Metropolitan PLC, which planned to launch a tender offer for Pillsbury, Mr. O'Hagan acquired a large number of options in the company. Following the announcement of the tender offer, the options soared, resulting in a four million dollar gain. After being found guilty on fifty-seven charges, the conviction was overturned on appeal. The case eventually found its way to the Supreme Court where the conviction was reinstated (for more information, read Getting the Appropriate Misappropriators: An Analysis of the Supreme Court's Decision in   United States vs. O'Hagan ).

Barry Switzer, then-Oklahoma football coach, was prosecuted by the SEC in 1981 after he and his friends purchased shares in Phoenix Resources, an oil company. Switzer was at a track meeting when he overhead a conversation between executives concerning the liquidation of the business. He purchased the stock at around $42 per share, and later sold at $59, making around $98,000 in the process. The charges against him were later dismissed by a federal judge on a “lack of evidence”.

On the other hand, based on precedence in other cases, Switzer probably would have been fined and served jail time if one of his players was the son or daughter of the executives, and mentioned the tip to him off-handedly. The line between ‘criminal’ and ‘lucky’, it seems, is almost entirely blurred in such cases.

Section 16 Requirements: Safeguards Against Insider Trading

In order to prevent illegal insider trading, Section 16 of the Securities and Exchange Act of 1934 requires that when an "insider" (defined as all officers, directors and 10% owners) buys the corporation's stock and sells it within six months, all of the profits must go to the company. By making it impossible for insiders to gain from small moves, much of the temptation of insider trading is removed. Company insiders are also required to disclose changes in the ownership of their positions including all purchases and dispositions of shares.

Insider trading often invokes an image of illegal activity. You know, when someone with knowledge the rest of the stock market doesn't have makes a killing.

Say you found out before anyone else in the market that a company just signed a big contract that would shoot its stock price up.

You could buy a big block of stock before any public announcement and make a bundle when the market learns the good news.

Or someone tips you off that a company is about to be hit with a big scandal. You could short the stock and make a large profit when the stock falls in price.

Regulators watch trading activity before and after big moves in a stock's price to spot any unusual activity.

Insider trading in this context is illegal - you can't profit from information that is not available to the whole market.

However, there is another type of insider trading that is legal and you can watch for clues about where stock prices are headed.

Officers and executives of publically-traded companies are called insiders, meaning they often have information before it is shared with the stock market.

The executives have some restrictions on the timing of purchases and sales of company stock, but for the most part they are free to trade.

However, unlike other investors, they must report their trades to regulators.

This prevents them from trading on insider information to the detriment of other stockholders.

They are also prevented from tipping off friends or others about impending news.

What can you learn from watching legal insiders trade?

According to a study reported on The New York Times, insiders give fairly reliable clues about price direction - not perfect, but right more often than wrong.

Where do you find insider-trading information?

One of the best sources for insider trading information is Yahoo Finance.

Enter the stock symbol for a company and you are taken to a financial profile page.

In the left-hand column are a number of links to financial information and various ratios.

Under the "Ownership" heading you'll find several features on insider transactions.

There you can see whether officers are buying or selling shares, including exercising options.

Following the actions of one officer may not be helpful as personal financial decisions may drive their actions (kid starting college, for example).

However, if you look at what all the officers are doing as a group - are more buying or selling - you can get a glimpse of where they think the stock is headed.

The study noted that insiders have missed some big events, but overall they out perform the market with regular consistency.

Watch the insider trading action for awhile and use that information along with other research to suggest a trading strategy.

Insiders

The SEC classifies key employees and directors as insiders and requires them to register their trades of company stock with two trading days. For example, if the CEO of a company buys or sells 500 shares he or she is required to notify the SEC within two days of the trade.

That information is public and available to any investor. As long as the insider is trading on information that is generally available to the public no laws are broken.

However, if the CEO knows the company is not going to get a big contract and sells before telling the world, that’s illegal.

You can find insider trades on a number of websites including MSN Money.com   andYahoo!Finance.   On both sites, enter a stock symbol and navigate to the insider link.

How to Use Insider Trading

If the trades are legal, what do they tell you and how can you use them?

When corporate insiders, especially senior executives buy or sell company stock, it is worth considering why. Let’s look at the sell side first.

The fact that a corporate officer is selling shares may or may not tell you something of value. People sell for a variety of reasons, only one of which may be that the stock is headed down.

Much of executive compensation is in the form of stock so this may be a way of converting that compensation into cash and have nothing to do with the fortunes of the company. The executive may have a tax bill, a divorce, or a vacation to fund. Maybe he or she wants to diversify their portfolio. Frequently, companies will issue press releases detailing why executives are selling to calm fears in the market.

However, if you see several key executives selling at the same time it might be worth taking a close look at the company’s fundamentals again.

Insiders Buying

When corporate insiders are buying stock, the signals are a little easier to understand. You typically buy for one reason – because you believe the price of the stock is going up.

This doesn’t mean it is going to pop next week. Frequently, executives buy way out to avoid the appearance of illegal insider trading. However, if key executives are buying stock it is usually a good sign.

Don’t be misled by single purchases, however. Most companies require top executives to own stock and will lend them money to buy shares. A new executive may buy a sizable block regardless of the future prospects simply because it is expected.

Conclusion

It makes sense that insiders know more about the company than anyone, so watching what they do is another tool you can use. Here are some points to remember:

People sell for a number of reasons – don’t jump to conclusions Don’t put too much importance on the actions of individuals – look for

trends Insider trading is only one tool, not a magic bullet; use it along with you

other evaluation tools

Martha Stewart has been in the news for several months because the U.S. Securities and Exchange Commission believes that Martha Stewart was told by her friend Sam Waksal that his company ImClone’s cancer drug had been rejected by the Food and Drug Administration before this information was made public. This rejection was a huge blow to his company and the price of its stock went down dramatically. However, Martha Stewart wasn’t financially hurt because she had her broker sell her 4000 shares before this news was made public. If this is true, and it should be noted it hasn’t been proven yet, then Martha Stewart is guilty of insider trading.

What Is Insider Trading?

When most people hear the term “insider trading” they think of the illegal version. However, the term “insider trading” can also mean the perfectly legal buying and selling of stock by a company’s corporate insiders. Insider trading is legal when these corporate insiders trade stock of their own company and report these trades to the U.S. Securities and Exchange Commission (SEC). That way the insider trading is not kept a secret and anyone can find out a corporate insider’s opinion of his or her company.

Insider trading is only illegal when a person bases their trade of stocks in a public company on information that the public does not know. It is illegal to trade your own stock in a company based on this information but it is also illegal to give someone that information, a tip, so they can trade their stock.

Why Is Insider Trading Illegal?

The SEC’s job is to make sure that all investors are making decisions based on the same information. Insider trading can be illegal because it destroys this level playing field.

Punishments and Rewards Associated With Insider Trading

According to the SEC website there are almost 500 civil enforcement actions each year against individuals and companies that break securities laws. Insider trading is one of the most common laws broken. The punishment for illegal insider trading depends on the situation. The person can be fined, banned from sitting on the executive or board of directors of a public company and even jailed.

The Securities Exchange Act of 1934 in the United States allows the Securities and Exchange Commission to give a person a reward “a bounty” to someone who gives the Commission information that results in a fine of insider trading.

New mobile recording regulations to fight insider trading

New rules which mean financial services companies have to record traders’ company mobiles will benefit the industry, says Voxsmart

The country’s sole provider of software-only mobile call recording solutions for BlackBerry smartphones says the new Financial Services Authority (FSA) regulations will help improve the image of the sector in the long term.

From November 2011, all FSA regulated investment firms in the UK, from banks to high street stockbrokers, will have to record traders’ mobile phone conversations and store them for six months. This has caused an outpouring of discord in the industry with companies concerned that it could prove costly to implement.

Voxsmart’s Chief Executive Sally-Ann Angel has worked closely with the FSA during the development of the new rules. She said businesses should focus on the benefits of the new regulations rather than rally against them.

She explained: “The FSA’s recording requirements have been drawn up to crack down on insider trading and provide the FSA with evidence to convict rogue traders. Recording calls on traders’ desk phones has been a requirement for some time and by closing the loophole to include recording mobiles as well, the FSA is sending out a clear message that they are serious about preventing and detecting market abuse.”

Angel stressed that the City’s concerns about the high costs to implement new mobile recording systems are unfounded. “This is not the case,” she said. “Voxsmart offers a software-based solution which means companies can easily and securely record their BlackBerry smartphones on their current landline recording equipment without the need to purchase any new hardware. And because all calls are kept on the mobile network there are no costly call re-routing charges to pay, either. We are the only company to supply this solution, which costs a fraction of the frightening amounts being quoted in the industry.”

Angel explained that like all BlackBerry applications, Voxsmart’s VoxRecord is very simple to set up using the BlackBerry Enterprise Server. Calls are made in the same way as normal, with the resulting MP3 or WAV file securely created and stored on the company’s existing voice recording systems and all data kept securely within the company’s own firewalls.

“Alternatively, companies without an in-house voice recorder, can take advantage of the cloud based service offered by Voxsmart,” added Angel.

She added: “VoxRecord is accredited and distributed by leading call recording systems suppliers and resellers. It is a proven solution that is already being used in financial centres in London and around the world and is the published BlackBerry case study for mobile voice recording.”

 Insider Trading  and Fraud 

Officers, directors,  and key employees obtain advance inside  information about matters that can affect  the future value of stock

Insider trading is prohibited by the 1934 Act

Sec. 16 defines insiders are directors, officers, and owners of more than 10% of any one class of stock

Any profit made within a six month period is illegal

The Journal of Finance © 1992 American Finance Association.

Can Insiders Help You Make Better Trades?r trading is a term that conjures up visions of illegal backroom dealing to buy and sell shares on information not available to the public. We have all heard of cases of illegal trading by corporate heads (see Defining Illegal Insider Trading), but thousands of shares are bought and sold weekly by corporate insiders. This insider activity is perfectly legal as long as proper guidelines are followed. More importantly, it may be a valuable tool that helps you enhance your trades. Definitions and Regulations An insider is defined as an officer, director or owner of 10% or more of a class of shares in a corporation. This includes not only executives working for companies, but also other entities such as mutual funds, hedge funds or institutions that hold an amount equal to or greater than 10% of issued and outstanding shares. Insiders are required to follow a strict set of rules as determined by the Securities and Exchange Commission (SEC), which includes reporting any trade in a timely manner. These rules have been toughened by the commission to define more clearly the circumstances under which insiders can trade, further tipping the scales in the public's favor. 

In the wake of a number of Wall Street scandals, the U.S. Congress took part in a cleanup effort. Following the Enron debacle, Congress enacted the controversial Sarbanes-Oxley Act of 2002. This act mandated some powerful changes to reporting requirements. According to Lon Gerber, director of insider research with Thomson Financial, insiders are now required to report trades by the second day following the transaction, rather than the 10th day of the month following the trade as was required under the old rules. This reporting requirement goes a long way toward levelling the playing field for retail investors, making insider data a far more effective and timely tool in the process. The Data Figure 1 is a chart of the S&P 500. For figure 2, which is a bar chart of the ratio of insider shares sold to shares purchased in dollars, Thomson Financial provided insider-ratio data, which was then plotted using a spreadsheet program and then constructed into a bar chart. 

Figure 1 – Weekly chart of the S&P 500 between 1997 and 2003. Numbers below price correspond to periods of low insider selling (high buying) and numbers above the price chart to periods of high insider selling in figure 2. Green lines are the 30-day highs and red lines, the 30-day lows. Chart provided by MetaStock.com

  

Figure 2 – The ratio of shares sold to those purchased in dollars between January 1997 and October 2003. When the ratio is at extreme low levels, insiders are buying. Based on the comparison to the weekly chart of the S&P 500 (figure 1), investors and traders who followed the lead of insiders would have done quite well. When the ratio was at high levels, insiders were selling. Data provided by Thomson Financial.

A number of publications report insider transactions weekly from data provided by Thomson Financial. Two well-known sources are the Wall Street Journal's “Insider Spotlight” and Barron's insider transactions reports. Free insider transaction data on individual stocks is also available from sites like Yahoo Finance. It is a simple matter to download the data each week into a spreadsheet and analyze it in your favorite charting program. 

Analyzing the Insider Data What was the relationship between insider transactions and stock price during the last six years? As we analyze these charts, we can determine whether high insider buying activity (when the ratio is extremely low) coincided with good times to buy in the market, and whether extremely high levels of insider selling activity (when the ratio is high) would have indicated that it's a good time to sell. As you can see from figures 1 and 2, traders who took cues from insiders when they bought (the sell/buy ratio was lowest) would have done quite well. Low points at points 1, 3, 5 and 7 (in figure 2) in the bull market, during which insiders were doing the largest amount of buying, would have netted copycat traders excellent returns. In the bear market, buying when insiders did at points 10, 12, 14 and 16 would have been a good strategy, even though you would have been trading against the trend. 

What was the relationship between insider transactions and stock price during the last six years? As we analyze these charts, we can determine whether high insider buying activity (when the ratio is extremely low) coincided with good times to buy in the market, and whether extremely high levels of insider selling activity (when the ratio is high) would have indicated that it's a good time to sell. As you can see from figures 1 and 2, traders who took cues from insiders when they bought (the sell/buy ratio was lowest) would have done quite well. Low points at points 1, 3, 5 and 7 (in figure 2) in the bull market, during which insiders were doing the largest amount of buying, would have netted copycat traders excellent returns. In the , buying when insiders did at points 10, 12, 14 and 16 would have been a good strategy, even though you would have been trading against the trend. What about selling when insiders did? According to Gerber, insider buying is a good signal to follow but insider selling is a little trickier. Insiders use restricted stock and options(issued in lieu of cash) to supplement or, in some cases, virtually replace standard paychecks, so using this data to determine when

to sell is less exact. When insiders are buying their own stock, they do so because they believe the stock is going up. When they sell, however, they could be doing so for a number of reasons, not simply because they believe share value may drop.   Phil Roth, senior technical analyst for Miller Tabak & Co., frequent guest on CNBC and one of the first recipients of the Chartered Market Technician designation, had this to say in an e-mail responding to questions about insider sales: "It is important to remember that most insiders are investors, not traders and they tend to buy shares in the company when they are cheap and sell when they are expensive. They are not as motivated by trends as are traders. Insider transactions have proven to be a better buy than sell indicator in my experience for the reasons you outline [in the two paragraphs above]." 

This may explain why the market as represented by the S&P 500 (figure 1) did not drop significantly every time the insider sell/buy ratio hit high levels. By following the insiders' lead to sell as evidenced in figure 2 at points 2, 4 and 6, the trader would have been left out of the upside action that followed. Selling when insiders did would not have begun to pay off until the market began to turn at points 8 and 9. 

During the bear market, selling with the insiders at points 11, 13 and 15 would have been a better strategy. Although an extreme level of insider selling in a bull market should not be used as an independent sell signal, it does beg the question: when insiders are unloading their shares like there is no tomorrow, is it really the best time to buy?   Conclusion – Remember to Use Other Tools There is little doubt that as a sentiment indicator, insider buying and selling can be an effective trade confirmation tool when used in conjunction with other technical indicators such as trend lines and moving average crossovers by those who know how to read the signs. 

It is imperative when using any sentiment indicator that a trend line be broken before a signal is acted upon, but it is clear that insider transactions have provided useful early warning signals in the last six years. For more on insider trading see When Insiders Buy, Should You Join Them? and Uncovering Insider Trading. 

by Matt Blackman (Contact Author | Biography)

Matt Blackman, the host of TradeSystemGuru.com, is a technical trader, author, keynote speaker and regular contributor to a number of trading publications and investment/trading websites in North America and Europe. He also writes a weekly market letter.

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