What Is Insider Trading?

For all of you traders out there, you may want to beware of insider trading.

In case you weren’t aware, there are unscrupulous traders out there who buy or sell stocks, securities and currencies based on non-public information they have access to.

These traders are for example, owners, CEOs, directors, or other upper-level management employees of large companies along with anyone who knows them such as family or friends.

Insider trading is an unlawful and unfair form of trading which takes place by individuals who make trades based on utilizing private or stolen company information they can use to their advantage.

Because they have access to such facts, their likelihood of making a profit is a most likely a sure one.

Why is this bad?

Because they are depriving public traders the chance of doing the same and are hindering the overall performance of the market.

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How Insider Trading Works

You can think of insider trading much like cheating on a test, especially a job-skills test where those who score the highest are most likely to get hired.

The insider trader would be analogous to the person(s) that somehow get secret access to the answers before the test is to be taken.

Hence, they have an unfair advantage over all the other applicants.

How is valuable data passed along in insider trading?

Let’s take the following first scenario:

Let’s say the Director of ABC Inc has the results announcement due to be released by, say Wednesday to the London Stock Exchange.

Assume that the announcement is going to hurt the ABC’s shares price since this company isn’t doing as well as the public believes it is.

Monday, in a phone conversation with a hedge funds manager, the director accidentally let’s the info slip.

While at lunch, that manager has a few drinks with his lawyer and thus mistakenly tells him.

Monday night, the lawyer then informs his wife over supper that ABC’s announcements are not too good So on Tuesday, she sells all her ABC shares to avoid taking a loss on them.

She then can be nailed for insider trading.

So, what makes insider trading just that? It consists of the following:

– The insider:

This could be any employee of a company, especially upper management or perhaps anyone they interact with on a daily basis.

Anyone that a company member passes confidential info to is considered an insider including friends, relatives, or spouses.

– Price sensitive information:

Such info is any type of fact(s) or advice that encourage one to buy or sell stock based on good news or bad.

If this info leaks out early, it will directly affect the share value of the company involved or.

Simply put, this is tomorrow’s information shared today.

– Deal:

A deal is simply the act of knowingly passing on info that is confidential and illegal at that.

Anybody with access to inside info who passes it on to others is part of the deal.

Passing inside info to any outsider (or non-employee of your company) is illegal whether it is witnessed or not.

That also goes for professionals that accompany you in your trading activities such as hedge funds managers or lawyers.

Proving Insider Trading Activity

Then comes the aspect of insider trading: proving that it has happened.

Distributing inside info or accepting it is a crime and carries criminal penalties, large fines, and prison sentences.

In the case of court action, a jury needs to be persuaded beyond a reasonable doubt, that a suspect has committed a crime.

This plays as a standard test.

Because such crimes carry big penalties including imprisonment, the bar is set quite high and it’s the jury that decides whether or not insider trading activity has taken place.

Insider trading is even more difficult to prove. In an insider’s dealing case with multiple networks of information, phone conversations, emails, tricky deals, etc, it can all quite complicated to actually prove it has occurred.

As for the defendants, they’ll deny that it happened and such communication was done only as part of their job.

Because it isn’t easy to prove, many who commit to insider trading who should be prosecuted are not.

– The SEC Versus the Supreme Court

Currently, we have two inconsistent laws of insider trading simultaneously at war with one another in the United States.

One is a law promulgated by the Security & Exchange Commission (SEC) in its enforcement program.

The second set of laws is the law of insider trading that has been articulated the the US Supreme Court in a series of views that the SEC dislikes or rejects.

What are theses views and how do they differ?

The SEC feels that insider trading should be illegal since it is unfair.

This is because when one person trades with another with an inappropriate informational advantage, such an act is unfair to public traders.

However, the Supreme Court takes a completely different view.

Rather than focusing on the counter party, the Supreme Court addresses the source of the information.

They determine whether the person engaged in this trading activity has stolen the info from its rightful owner.

Hence, we can call the SEC’s viewpoint to insiders trading as the fairness approach and coin the Supreme Court’s viewpoint as the business property approach.

Both views can be analyzed as to who is harmed under these distinct theories.

A second scenario demonstrates how differently the SEC and the Supreme Court view insider trading:

Say, a hedge managers gets inside info on how the ABC firm’s bid for the XYZ firm.

Hence ABC is the acquiring entity and XYZ is the company to be purchased or taken over.

ABC plans to pay a large premium for XYZ’s stock.

Anybody who gains inside knowledge of this unannounced bid could use it to their advantage:

by making a lot of money through purchasing shares of XYZ and then reselling them after the bid has become public.

How do these legal entities view this?

The SEC sees it as being unfair to XYZ (the seller of the stock) as they are not yet aware of ABC’s intention of acquiring their firm.

Thus, those who buy XYZ’s stock based on these facts are at fault.

On the other hand, the Supreme Court says the person doing this trading has no preexisting obligation to trade duty to this counter-party (XYZ).

What we care about is that whoever is making a trade has in essence stolen this information from the bidder (ABC).

Hence, the Supreme Court feels that the persons spreading the inside info are at fault, not the buyers of XYZ’s stock.

However, the SEC has what they call an Insider Traders Enforcement Program.

The way they find insider traders is by investigating those who have made a great amount of money on a recent buying or selling activity, especially those who’ve traded on a repetitive basis.

Hence, they look at hedge funds and private equity firms and look at the returns these firms make when investing in company stocks.

If alleged inside traders lose money, the SEC pays no attention to them.

However, if specific traders make money consistently, the SEC suspects these people have engaged in insider trading.

Once the SEC finds traders who have repeatedly outperformed the market based on its theory, this organization will investigate them, create a lawsuit against them, and once evident, throw them in jail.

Conclusion

Imagine that you trade stocks or securities.

What if someone lets you in on a secret as to what stocks to buy or sell?

Would you be elated with their advice or would you question it?

What if it were a friend, relative, or family member?

Should you follow their advice?

Absolutely not!

Your best bet would be to question them and find the source of this information.

More than likely, they may be engaging in insider trading.

Hence, if you gladly take their advice and do what they ask you to do, you are guilty just the same.

That’s if you get caught.

Remember, inside trading is a crime whether you inform others of non-public trading information or act on it yourself.

If caught, you may face big fines, imprisonment, or both.

If you are suspicious that one is committing such an act, refuse to cooperate and if you can remain anonymous, report them.

No amount of money is worth the risk.

Published by

Lucian Serna

I am an experienced entrepreneurs and marketer. I always liked to writing about what I know. LuckScout has given me the chance to write and share my knowledge and experience with people.

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