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What Is Insider Trading and How Could it Affect Your Investments?

November 23, 2020 12:26 UTC

You may have come across the term "insider trading" whilst reading articles about the financial sector. When it happens it can have an impact on a company's share price. But what is it? And how does it affect investors? In this article, we will discuss the answer to these questions - and many others.

What is Insider Trading

What Is Insider Trading?

Insider trading refers to the act of trading the securities (stocks, bonds, etc.) of a listed company based on information about the company which is not publicly known. In many countries this form of trading is illegal, but the laws which govern it differ greatly between them, as do the consequences of conviction.

Perhaps the easiest way to explain this concept is through an example:

Several days before Company X releases its annual results, one of its directors discloses to a friend that Company X has vastly over-performed, exceeding all expectations regarding annual earnings.

If this friend then purchases stock in Company X, with the expectation that the coming results will cause the share price to increase, before this information is made public, both would be guilty of insider trading.

Even if the director in our example disclosed the information inadvertently or accidentally left the information lying around where it could be read, he would still be heavily investigated and possibly charged.

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How Do People Get Caught?

People buy and sell individual stocks every day during the opening hours of the stock market. So how do people get found guilty of insider trading by simply placing trades in the stock market?

The financial markets are heavily regulated and there are teams of people whose primary job is to monitor the markets, looking for anything suspicious or out of the ordinary. When a listed company makes an announcement which has an impact on share price, these people are very likely to go back through stock market activity before the announcement and look for any unusual transactions which may cause alarm bells to ring.

Example:

Going back to our example in the previous section, once our investor became aware that Company X's annual results would likely cause its share price to shoot upwards, let's say he buys $100,000 worth of Company X shares, before the report is released.

If a market regulator saw this large transaction conveniently taking place just before the annual results were announced, they are likely to take action and investigate. If their investigation unearthed that this investor was an associate of one of Company X's directors, they would have reason to step up their investigations.

Similarly, if they saw a large trade from someone who never trades, or who normally trades in small sizes, that would raise suspicions.

Therefore, if you have any friends or family employed by listed companies, who may from time to time be the recipient of pertinent, non-public information, which could influence share price, don't be tempted to buy or sell stock based on this information should you unwittingly become its recipient!

Why Is It Illegal?

Simply put, insider trading is illegal because it is seen to be unfair to investors who did not have access to the crucial information upon which the trade was made. Organisations such as the Securities and Exchange Commission (SEC) in the US and the Financial Conduct Authority (FCA) in the UK oversee the financial markets and attempt to maintain an even playing field.

There was a time when insider trading was completely legal in most markets. Then thinking evolved to regard it as a "victimless crime".

But, if you imagine yourself selling a long term holding to an insider just before an announcement that makes the share price rise dramatically - and focus for a moment how you would feel (you probably would not have sold if you knew the same information and you could have missed out on a big profit). Now it's more obvious that it's not really a victimless crime.

Are "Insiders" Allowed to Buy Stock?

Company directors, employees and people close to both groups are free to buy and sell shares of the company in question, however, in developed markets like the UK and EU, they must declare their trades to the relevant authority. If they are later found to have been in possession of non-public price-sensitive information, they will be investigated.

To avoid problems, most listed companies have rules that prevent any "insiders" from trading in the run up to sensitive announcements, like annual results, alternatively their trades may have to be cleared internally first.

Information about the buying and selling of a company's stock by its directors, and their close associates, is publicly available and reported weekly in various financial outlets, like the Financial Times or the Investors' Chronicle.

There are even products that take this to the next level and, for example, supply the trading history of individual directors and provide a ranking for each director, or "insider", on how profitable their trades have been in the past. After all, it is not illegal for insiders to trade, it is just illegal for them to do so based on sensitive information that is not public.

Who is Considered an "Insider"?

"Insiders" are not just the people who work inside a particular company. The rules apply to other people, outside the company, who come across sensitive financial information - bankers, fund managers, lawyers, accountants and so on.

There was even a case a few years ago of an insider trading "ring" centred around a printing business. The business was a specialist printer that often handled sensitive documents like annual reports and financial prospectuses. One of the employees realised how valuable the information was and organised a group of people around him to take advantage of it. It all worked well, until they got caught.

Why Is This Important for Investors to Understand?

Some of you might be thinking "What has this got to do with me? I am not the director of a listed company and I don't have access to any non-public information which could benefit my investments."

Whilst this may be the case, one problem with insider trading is that, it not only results in hefty fines and possible prison sentences for those who are complicit, but it can also have a negative knock on effect on the stock of the company involved.

Amazon: Insider Trading in Action

A recent example of insider trading and how it affected share price can be found from online retail heavyweight Amazon.

On 28 September 2020, the SEC charged a former Amazon finance manager and two of her family members with insider trading. This allegedly took place between January 2016 and July 2018 resulting in earnings of approximately $1.4 million.

On 5 November 2020, the husband of the former Amazon finance manager pled guilty to the charges. When trading opened the following day, 6 November, indicated by the red vertical line in the chart below, Amazon's share price fell more than 2% to $3,248.11.

Amazon M15 Chart MetaTrader 5Depicted: Admiral Markets MetaTrader 5 - Amazon M15 Chart. Date Range: 3 November 2020 - 10 November 2020. Date Captured: 11 November 2020. Past performance is not necessarily an indicator of future performance.

Amazon Daily Chart MetaTrader 5Depicted: Admiral Markets MetaTrader 5 - Amazon Daily Chart. Date Range: 10 February 2016 - 24 November 2020. Date Captured: 24 November 2020. Past performance is not necessarily an indicator of future performance.

The share price recovered most of its losses throughout the day and at the final bell closed at $3,308.91. However, when trading resumed on Monday, 9 November, Amazon's share price opened at $3,124.44. A fall of more than 5.5% over the weekend. The share price continued its downward trajectory the following day.

Can I Use This Information to My Advantage?

Unfortunately, as with many fundamental events, by the time you hear about insider trading convictions, as a shareholder, it might be too late to take action.

However, for those who are not shareholders, a guilty conviction of insider trading may present an investment opportunity. If you are interested in buying shares in a company and then a case of insider trading involving that company is prosecuted, the bad press will likely cause the share price to fall.

A savvy investor, who regards something like this as only a temporary embarrassment for the company and believes that the shares will surely bounce back, might take advantage of the lower share price.

Going back to our Amazon example, if I bought shares just before the market closed on 10 November 2020, they would have cost me around $3,045 as opposed to the $3,320 the day prior to the announcement of a guilty plea in the insider trading case.

Final Thoughts

There are opponents to insider trading remaining an illegal activity, who cite other industries where people are able to profit freely from superior knowledge to their counterparts. However, as we have seen, for good reason, insider trading is illegal in many countries with market regulators working hard to ensure the financial markets remain as fair as possible for everyone concerned.

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.