How to Interpret Insider Trading (Plus Examples)

 

Interpret Insider Trading

While automotive officials were making brave and uplifting speeches about industry prospects, they were selling off stock in their own companies. We previously wrote on How to Evaluate High Technology Stocks.
 
When insiders like auto executives won’t leave their money where their mouths are, that’s worth knowing about. How to interpret insider action:

Insider selling

This is not as reliable an indicator as insider buying. Reason: There are all kinds of personal reasons why an insider might sell shares. However, if there is consistent insider selling, and only selling, it may be an early warning sign of poor performance.
 
Example: One California-based computer company’s troubles didn’t become apparent until some 18 months after considerable insider selling had been recorded.

Insider buying

It has a definite correlation to stock performance if it occurs in the open market rather than as a result of exercising options or warrants or as part of a profit-sharing plan. (However, if insiders are exercising those options, it reflects some optimism about the company.)

Watch for

Three or more insiders buy within a short period of time (several weeks). This often indicates that there are merger talks being conducted. However, it is not a confirmation of a takeover. Consistent inside chasing by officers, directors, investors, advertisers, and other affiliated groups means confidence in strong earnings potential and, therefore, a stock price that is higher.

Big block purchasers

The Securities and Exchange Commission (SEC) requires individuals or firms that acquire 5% or more of another company to state their purchase and purpose in a 13-D statement and record all additional purchases. Although 90% of the time the purchasers claim to be buying for investment purposes, it is frequently the first step toward a tender offer or merger. Even if a tender offer is not made, these investors usually do not buy into a company unless the underlying fundamentals warrant it.
To find out where insiders are placing their bets, you can follow their activities by using the SEC’s Official Summary and newsletters such as The Insider’s Chronicle. Both publish data three to six weeks after actual insiders’ purchases or sales are made. (The filings themselves are made 10 days after the insider trade.)
 
You can learn more about insider trading here.

Examples of Insider Trading

  1. A lawyer representing the CEO of a company learns in a confidential meeting that the CEO is going to be indicted for accounting fraud the next day. The lawyer shorts 1,000 shares of the company because he knows that the stock price is going to go way down on news of the indictment.
  2. A board member of a company knows that a merger is going to be announced within the next day or so and that the company stock is likely to go way up. He buys 1,000 shares of the company stock in his mother’s name so he can make a profit using his insider knowledge without reporting the trade to the Securities and Exchange Commission and without news of the purchase going public.
  3. A high-level employee of a company overhears a meeting where the CFO is talking about how the company is going to be driven into bankruptcy as a result of severe financial problems. The employee knows that his friend owns shares of the company. The employee warns his friend that he needs to sell his shares right away.
  4. A government employee is aware that a new regulation is going to be passed that will significantly benefit an electricity company. The government employee secretly buys shares of the electricity company and then pushes for the regulation to go through as quickly as possible.
  5. A corporate officer learns of a confidential merger between his company and another lucrative business. Knowing that the merger will require the purchase of shares at a high price, the corporate officer buys the stock the day before the merger is going to go through.

  • Bottom line

  • Insider trading has many forms, and based on the historical evolution of those forms, insider trading will likely continue to evolve and surface in tomorrow’s business world. 
  • However, educating your company on the common ways insider trading scenarios occur can prove to be the most effective tool in preventing the tangible and intangible damages that come from insider trading

 

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