What is Insider Trading?

What is Insider Trading?
TradeGM Analysis date_range February 23rd, 2021

Suppose a trader becomes aware of some private information about a publicly-traded company and proceeds to trade securities of that company due to said information; this is insider trading. Let’s take a look at the example below.

You are the CEO of company XYZ. The financial director has just brought the annual report to you, showing that the company’s profits exceeded all expectations. You agree to reveal this information to the public in two weeks’ time. But for now, you decide to take the financial director out for a celebratory lunch. You leave the report on the desk, and your secretary happens to see it while you’re out of the office. Anticipating that the company’s stock price will go up once this information becomes public, the secretary decides to buy more shares in the company. She has now committed insider trading and implicated you in the matter too.

One could be found guilty of insider trading even if no intent is established, meaning that even reckless or inadvertent disclosure of sensitive information can be considered insider trading.

Insider trading is considered illegal in many countries and can be punishable by a prison sentence. It is illegal because it provides an unfair advantage to an investor who had access to crucial information upon which the trade was executed.

Who can be accused of insider trading?

According to Investopedia, an insider is anyone within the company that has access to its’ sensitive information; or anyone who owns a minimum of 10% equity in the company.

Does that mean that the management and employees aren’t allowed to trade shares of the company they work for? No, they can trade any stock they may have. Insider trading can be legally provided that a certain protocol is followed.

Insiders (employees, CEO, etc.) are allowed to trade company shares; however, the transactions must be registered with the SEC (Securities and Exchange Office) or equivalent regulatory authority. That’s known as legal insider trading, and it happens relatively frequently. For instance, Warren Buffet trades shares of Berkshire Hathaway subsidiaries all the time.

How do the authorities spot insider trading?

If everyone is allowed to trade a company’s stock as they please, how would the relevant authorities know its insider trading? Financial markets are heavily regulated, and more often than not, there’s a team of individuals who examine all transactions that took place before any financial information went public. If they suspect insider trading, they will open an investigation.

Although insiders are allowed to trade any stock they have, most companies will have rules preventing them from trading securities in the run-up to sensitive financial announcements to avoid complications.

What are the effects of insider trading?

When someone in a company is accused of insider trading, it is usually followed by heavy fines or even prison sentences for those who are complicit. However, often the company ends up harmed too.

For instance, Amazon’s senior manager and two of her family members were charged with insider trading in 2020. The day after her husband pled guilty to the charges, Amazon’s stock took a 2% dive and then fell 5.5% over the weekend.

Conclusions

Once upon a time, insider trading wasn’t considered illegal. In fact, in a 20th-century ruling, the Supreme Court of the US mentioned that it was a perk of being an executive. It was only after the 1920’s that insider trading became illegal. Today, the SEC (or equivalent) vigorously scrutinizes all suspicious trades.

Stay tuned for our next post, where we will look at some famous cases of insider trading!

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CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 75.42% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money. X