What Is Insider Trading, and Is It Always Illegal?

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What Is Insider Trading, and Is It Always Illegal?

What Is Insider Trading?

An insider is someone who has access to important non-public knowledge about a company or owns shares worth more than 10% of the company’s equity. This effectively makes a company’s directors and top executives insiders.

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Key Takeaways

  • An insider is someone who has access to important non-public knowledge about a business or owns more than 10% of a company’s shares.
  • Insiders are lawfully allowed to purchase and sell stock, but the transactions must be reported to the SEC.
  • Legal insider trading occurs often, such as when a CEO purchases back company stock or when workers purchase stock in the firm where they work.
  • Illegal use of non-public material information is usually done for financial gain.
  • The SEC monitors illicit insider trading by examining trade volumes, which rise when no news from or about the firm is provided.

Understanding Insider Trading

Legal Insider Trading

Insiders are legally entitled to acquire and sell shares of the company and any subsidiaries in which they work. These transactions, however, must be properly registered with the Securities and Exchange Commission (SEC) and are completed via advance filings. The SEC’s EDGAR database has information on this kind of insider trading.

Legal insider trading occurs often, such as when a CEO buys back stock in their firm or when other workers acquire stock in the company where they work. Purchasing shares by a CEO may often impact the price movement of the stock they possess.

A excellent example is when Warren Buffett buys or sells stock in one of the Berkshire Hathaway firms.

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Illegal Insider Trading

The illicit exploitation of non-public material knowledge for profit is the most notorious kind of insider trading. It’s vital to realize that anybody, even corporate leaders, their friends and family, or simply an ordinary person on the street, may do this as long as the information isn’t publicly known.

Assume the CEO of a publicly listed business accidentally announces their company’s quarterly profits while getting a haircut. If the hairdresser trades on this knowledge, it is unlawful insider trading, and the SEC may take action.

The SEC may detect illicit insider trading by examining the transaction volumes of any given stock. Volumes often increase once substantial news is released to the public, but when no such information is supplied and volumes skyrocket, this might serve as a red indicator. The SEC then conducts an investigation to discover who was responsible for the unusual trading and if it was unlawful.

A frequent misperception is that all insider trading is unlawful; however, there are two ways for insider trading to occur—one is legal and the other is not.

Insider Trading vs. Insider Information

Insider information is information about a publicly listed firm that gives a trader or investor an unfair advantage. Assume the vice president of an engineering department of a technology business overhears a meeting between the CEO and the CFO.

The CFO informs the CEO two weeks before the firm reveals its results that the company did not reach its sales objectives and lost money in the previous quarter. The vice president of the engineering department is aware that their acquaintance has stock in the firm and advises them to sell their stock immediately and try to begin a short position. Because profits have not been made public, this is an example of insider knowledge.

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Assume the vice president’s acquaintance then sells their stock and shorts 1,000 shares before the results are revealed. Insider trading is now outlawed. However, trading the securities after the profits are announced is not prohibited since they do not have a direct edge over other traders or investors.

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