Insider Trading

See Also:
Blue Sky Laws
Subscription (Preemptive) Rights
Accounting Fraud Prevention using QuickBooks
Binomial Options Pricing Model
Black Scholes Option Calculation

Insider Trading Defined

Insider trading is buying or selling stock based on nonpublic information that will affect the stock’s price. A company’s executives and directors have access to significant information regarding the company’s activities. These people could easily profit by buying or selling the stock based on the private information they have. However, doing so is illegal.
SEC regulations prohibits insider trading, in certain circumstances. The idea is that trading based on private information is unfair. If insider trading were legal, then insiders could make huge profits by buying or selling a company’s stock just before important information is made available to the public. This behavior would put the investing public at a tremendous disadvantage in terms of buying and selling financial securities.
Insider trading is not always illegal. Typically, someone labeled an insider will have designated windows of opportunity throughout the year in which to legally buy or sell the company’s stock. Executives and managers are often awarded stock options, CEOs and directors often own significant amounts of their company’s stock. These people should be able to buy and sell their stock. And they can, but they must do it according to the rules. Insiders must notify the SEC regarding their buying and selling transactions.
Under certain conditions, if an executive announces publicly that he will sell a certain amount of shares or value of stock at a specified date every year, then he may do so each year without it being considered illegal insider trading. Likewise, managers or executives with access to nonpublic information may buy or sell stock after that information has been made available to the public.

Insider Trading Example

For example, imagine an executive at a large publicly traded corporation who sees the company’s income statement before it is issued to the public via the annual report. The executive sees that the corporation suffered big losses in the current period. Once the Wall Street analysts see these numbers, the company will be downgraded. Thus, the stock will decline.
If insider trading were allowed, then the executive could quickly go out and sell the company’s stock short, or else he could tell his broker and his friends and family members to sell the stock short. Selling a stock short makes a profit when the stock price goes down. When the reports are finally made public, the stock will plummet. Then the executive and his friends and family all make a lot of money. Meanwhile, the investors who owned the company’s stock but did not have access to the private information suffered losses.

Who is an Insider?

Technically, an insider is anyone who has access to material nonpublic information regarding a company. Examples of insiders include executives, directors, managers, shareholders with a 10% or greater stake in the company, and the close family members of these people. Insiders may also include lawyers, brokers, investment bankers, and printers of financial documents. It is illegal for insiders to buy or sell a stock based on material nonpublic information.

What is Insider Information?

Inside information is any material nonpublic information regarding a company that could affect the company’s stock price. The information is nonpublic if not yet disclosed to the investing public. The information is material if its disclosure could impact the company’s stock price. Examples of insider information include access to unreleased earnings reports, knowledge of a pending or imminent takeover or merger, or knowledge of any other kind that is of value to investors.
Download your free External Analysis whitepaper that guides you through overcoming obstacles and preparing how your company is going to react to external factors.