Insider trading: what it is and how to use it for profit
Imagine that you work for a company whose stock is trading on an exchange. One fine day, you learn that long negotiations with an important counterparty have been completed, and a major deal is about to take place. You know that, after such news, the company's stock price will definitely rise, as this deal will bring the company millions in profit for many years to come. Therefore, you buy the company’s shares – even before the information about the profitable deal becomes public and the stock price increases.
This practice is called insider trading – when company employees use non-public corporate information in stock trading.
What is insider trading?
In November 1963, Texas Gulf Sulphur Company discovered a rich copper deposit. The company’s CEO prohibited the members of the research team from disclosing this information, but in the following months, several employees of the company and associated individuals bought large amounts of the company's shares at a price of $17-20 per share. On April 16, 1964, Texas Gulf Sulphur Company announced their discovery. A month later, the company’s shares were worth $58 each, and employees who had purchased the shares three times cheaper made millions.
Insider trading is the act of conducting transactions based on material non-public information with the goal of gaining profit or avoiding losses.
Material non-public information
Material non-public information (MNPI) is any official information that has not been published and can influence investors' trading decisions and the market price of a company’s stock. Examples of such information may include research results, unpublished financial reports, and the outcomes of negotiations regarding the acquisition or sale of subsidiaries.
When buying and selling stocks, traders strive to gather as much information as possible about a company and its prospects. The vast majority of investors are in roughly the same position – they study publicly available reports and news. However, there are investors who gain an advantage over others – insiders.
Insiders are individuals who have access to information that has not yet been disclosed and may significantly affect the company’s stock price. These may be company employees, contractors, or individuals providing outsourced services, such as auditors, lawyers, or PR specialists.
By receiving significant information before other investors, insiders can decide to buy or sell stocks profitably before the news becomes public. After the official release of important information, the price of these securities will rise or fall, and insiders will make more money than other investors or avoid losses.
How insiders get profits on using MNPI
Legal and illegal insider trading
Access to material non-public information gives insiders an advantage over other shareholders. Therefore, to level the playing field, the U.S. Securities and Exchange Commission (SEC) has established Insider Trading Policy.
According to the SEC's definition, insiders include owners of more than 10% of company’s shares, directors, and “any other individuals who possess insider information due to their connections with the company or its directors and major shareholders.” Anyone who falls into this category must adhere to the following SEC requirements:
- Insiders must not buy or sell stocks based on material information known to them.
- Insiders are prohibited from disclosing material non-public information to third parties, including family members.
- Before obtaining any material non-public information, insiders must create a plan for their future trades involving the company’s stocks and follow it.
- Insiders must report their trades involving the company’s stocks.
This creates a unique “trap” for insiders: they are privy to confidential information but are not allowed to use it for personal gain. To enable insiders to trade stocks legally, the SEC established Rule 10b5-1, which is limiting and protecting insiders at the same time. Under this rule, they cannot trade stocks based on the company’s secrets known to them but can create a plan that allows for necessary trades without facing penalties.
Thus, trades based on insider information are illegal transactions. Legal insider trading refers to trades conducted by insiders that are not related to the use of material non-public information.
Legal and illegal insider trading
- Allowed to trade according to the plan
- Obliged to report every trade
- Can trade for personal reasons
- Can't access MNPI before making a trading plan
- Can't trade using MNPI
- Should not disclose or sell MNPI
Why monitor insider trades
Information about the transactions conducted by insiders helps traders make more informed decisions about buying or selling stocks. Although insiders cannot directly use material information for trading, their trades reflect their confidence in the company's future success.
How insider trading data helps
The effectiveness of using insider trade information for trading has been validated by numerous studies:
- In 2003, Jeng, Metrick, and Zeckhauser analyzed insider reports filed with the SEC from 1975 to 1996 and found that purchases generated abnormal annual returns of 6% for insiders.
- A 1998 study by Lakonishok and Lee revealed that stocks with higher insider purchases compared to sales delivered 4.82% higher returns than stocks with more sales.
- A 2002 study by Iqbal Zahid and Shekar Shetty demonstrated a positive correlation between insider trades and subsequent stock returns in approximately 60% of cases.
In 2010, Brochet found that even the restrictions introduced by the Sarbanes-Oxley Act did not reduce the profitability of insider trades.
The SEC identifies around 50 cases of illegal insider trading annually. This represents a minimum number of opportunities for ordinary traders to track these trades and achieve abnormal profits alongside insiders.
Where to find information on insider trades
Insiders are required to file their trades with the SEC within two business days of executing them. Data on insider trades is typically available in the EDGAR database within 24 hours of the filing date and time of Form 4 reports. If errors are discovered in the filed trades, the insider may file a corrective report (Form 4/A), which replaces the original trade information. Currently, the database contains over 21 million documents, with approximately 3,000 reports added daily.
The database search allows the use of operators like AND, OR, NOT, NEAR, and other tools.
Insiders submit three types of reports: Forms 3, 4, and 5. Form 3 is the initial statement of beneficial ownership, filed when an individual becomes an insider, such as when a manager purchases shares in their company. It must also be filed when an individual loses insider status.
Form 4 is the primary source of data on insider trades. It provides details on the number of shares bought or sold by an insider, the price, the transaction date, and the reason for the transaction. Each trade is marked with one of 20 letter codes, the meanings of which are explained in a special instruction guide to the form.
In this example, Form 4 reveals that the Chairman of the Board of Directors of Globalstar conducted two transactions, purchasing 500,000 shares for his company Thermo Properties II.
Form 5 is an annual report on the number of shares owned by an insider. It must be filed within 45 days of the end of the fiscal year. Comparing information from Form 5 at the beginning and end of the year with all submitted Form 4 reports helps identify trades that insiders failed to filewith the SEC.
How to use insider trading information
Whatever the reason insiders trade stocks, their primary goal is to gain profit. With access to non-public information and company secrets, insiders can derive greater benefits from their trades. Many researchers study the relationship between various parameters of insider trades and the subsequent performance of stocks. Here are some tips to help analyze insider trading activity:
Track key individuals important to the company. Create a list of people whose trades might signal significant undisclosed information. This list may include not only major shareholders but also executive directors, freelance consultants, auditors, and relatives of beneficiaries.
For example, in 2020, Elon Musk made headlines when he purchased large amounts of Tesla stock. At the time, Tesla's stock was trading at relatively low levels compared to its future potential. Musk’s purchase of shares was interpreted by many analysts as a sign of his confidence in the company’s growth. Six months after Musk’s insider purchase, Tesla’s stock price had more than doubled, reaching new highs as investors began to recognize the company's growing prospects in the electric vehicle market.
Pay attention to high-volume trades. The profitability of insider trades increases with trade volume. Researchers have calculated that when insiders sell stocks worth over $100,000, abnormal profits can exceed 12%. Large-volume trades in major companies can boost abnormal returns to as much as 30%.
Focus on purchases over sales. Stock purchases indicate insiders’ confidence in the company. Insider purchases are generally more informative than sales, which may be driven by liquidity needs or diversification. This is supported by several studies: Lakonishok and Lee (2001), Kallunki, Nilsson, Hellström (2009), and Brochet (2010).
Monitor simultaneous trades by multiple insiders within the same company. Research shows that when three insiders of the same company buy stocks simultaneously, it serves as a strong buy signal, indicating significant future price increases. However, this pattern is observed only in smaller companies and only for purchases, not sales.
Pay attention to insiders of smaller companies. Economists Lakonishok and Lee found that insider purchases in smaller companies generate the highest returns—around 7.2%. Due to their size, such companies attract less attention from financial analysts and brokers, meaning their stock prices reflect fewer projections.
Watch companies with high trading volumes. Theoretical models developed by Admati and Pfleiderer (1988) and Collin-Dufresne and Fos (2016) show that informed traders conduct transactions during periods of high stock liquidity to mask the impact of their actions on prices. Consequently, stocks with increased trading volume often have more insider trades based on undisclosed material information.
Pay attention to letter codes. When insiders report their trades, they must indicate the nature of the transaction using one of twenty transaction codes. Most transactions fall under a pre-arranged trading plan submitted to the SEC in advance. Insiders who report a purchase (P-Purchase) at a low price followed by a sale (S-Sale) at a high price are closely scrutinized by the Commission – they bought and then sold for profit, which may suggest the use of undisclosed material information.
Traders seeking to avoid SEC scrutiny might sell their shares under the “Other” code (J-Other), meaning “none of the above.” This code is intended for transactions that do not fit into any of the predefined categories. Insiders can structure their trades to potentially qualify for the J code or intentionally misclassify transactions. It is suspected that insiders leverage privileged access to corporate information to buy low and sell high, then conceal the transaction under the broad interpretation of this code.
Researcher N. Seyhan analyzed insider trades marked with the J code and found that over the following year, these trades yielded more than 8% abnormal profits above market returns. Trades with J codes made by top executives generated abnormal profits of about 14%.
Monitor reporting delays. The most informative trades are often delayed in their reporting, as noted in N. Seyhan's study. According to the researcher, trades reported within two business days contain no significant informational value. For trades reported with a delay of 3-20 days, abnormal returns average is 6.7%. When reporting is delayed by more than 20 days, abnormal returns increase to 10%.
Pay attention to the company's M&A activity. Approximately 50% of insider trading prosecutions by the SEC and the U.S. Department of Justice (DOJ) are related to mergers and acquisitions (M&A), according to Patel and Putniņš. However, only 15% of such cases are identified.
Don’t blindly copy Trades – analyze them. Not all insider trades signal something significant. Insiders may sell or buy shares for various reasons, such as following their SEC-approved trading plan or for personal financial needs. Blindly copying insider trades can lead to unnecessary purchases that deplete your funds, leaving you unable to act when a truly significant signal appears. Allocate a specific amount, analyze the trades, and wait for a signal supported by multiple factors.
10 tips for trading using insider deals information
Pros and cons: should you use insider trading information for trading?
Insider trading data is a tool that not only enhances a trader’s capabilities but also introduces additional challenges. When deciding whether to use insider trades for trading, it is important to consider the pros and cons of this approach.
Pros of trading based on insider trades
Insiders have information unknown to the market. Information about insider trades increases the awareness of other traders, allowing them to make more informed decisions when trading securities. Investors who monitor insider transactions gain additional insights into companies.
Insider trades are easy to find. This information is publicly available 24/7 in the SEC’s EDGAR database.
Using insider trading data is legal. While insiders are prohibited from trading based on undisclosed material information, other traders are not barred from using data related to insider purchases and sales for trading. If you replicate an insider trade based on corporate secrets, you will not face penalties.
Insiders often manage to gain profit without repercussions. Research shows that despite SEC restrictions, top executives, company employees, and other connected individuals still profit from undisclosed material information. This suggests that insiders have found loopholes in the laws, making their trades informative for other traders.
Cons of trading based on insider trades
Insiders do not always trade on undisclosed information. Most transactions by top executives and company employees are made according to pre-approved SEC plans or for personal reasons. Identifying trades that are truly significant for stock prices requires time-consuming and meticulous monitoring of Form 4 reports.
Delayed data availability. Insiders are required to file trade reports within two business days, but this delay can be too long for the market. Besides you, many other investors, financial analysts, and brokers are also monitoring major companies. With their extensive experience, expertise, and connections, they may detect insider trades or material information sooner. By the time you analyze the situation and make a decision, the market price may have already “followed” the insider signal.
Insider trades are difficult to analyze. The sheer volume of data is overwhelming: scattered SEC reports, news about management changes, rumors about M&A activity, and more. To correctly interpret insider trades and identify those based on undisclosed material information, significant time must be spent on tracking, grouping, and analysis.
Other factors may have a greater impact on stock prices. Insider trades are just one of many factors influencing the market. Stock prices can also be affected by competitor news, force majeure events, geopolitical developments, regulatory changes, and other external factors.
Pros and cons of trading using insider deals information
- Insiders have information unknown to the market
- Insider deals are easy to find
- Use of information about insider deals is legal
- Insiders manage to make profitable deals
- Insiders do not always trade using MNPI
- Delays in reporting
- Insider transactions are difficult to analyze
- Other factors may impact on the stock price
Thus, insider trading data helps traders make more informed and balanced decisions about buying or selling stocks. However, significant effort and time are required to uncover truly strong signals. Various services and platforms, such as Prismo, can help overcome these challenges.
How Prismo helps investors use insider trade information
Tracking insider trades can be challenging, especially for novice investors. Searching for and grouping information for analysis often has to be done manually. To stay ahead of the curve, investors need to constantly query reports from the database and meticulously examine each one.
Prismo offers an efficient solution for analyzing insider trades. This platform combines a comprehensive insider report database with analytical tools tailored for investors. Here’s how Prismo simplifies working with insider trading data:
Convenient presentation of trades by company and insider. All statistics on insider trades for each company and each insider are consolidated on a single page and categorized by trade type and position level. You can search the Prismo database by company name or symbol, enabling quick access to all relevant information in one place. Insider profile pages include details about the person’s relationship with the company, their trades (with links to Form 4), the total number of shares bought and sold, and the overall profitability of their trades. Data tables can be sorted in ascending or descending order, expanding investors' analytical capabilities.
Ready-made analysis of insider trades. Prismo analyzes insider trades by amount, profitability, type of insider, and other parameters. The platform also collects information on analyst recommendations and compares them with insider trade signals. This significantly speeds up the review and analysis of insider trading, allowing investors to draw conclusions and make profitable investment decisions.
Prismo aggregates all insider trade data into numerous informative tables and charts.
Notifications on insider signals. Investors can configure alerts based on transaction amounts, specific companies, and other indicators to be promptly informed of profitable buying or selling opportunities.
Stock rankings by insider purchase volume. Prismo users can explore a “heat map” of insider purchases, which is a special chart comparing the number of insider purchases and the volume of these transactions. This map provides insights into which companies attract the most insider interest. Additionally, a company size indicator helps investors choose stocks better suited to their strategies.
Utilization of a high-yield algorithm. Prismo analysts regularly publish investment reviews using an algorithm that, over a 17-year backtest, demonstrated an average return of 17.33%, nearly double the S&P 500's performance during the same period.
How Prismo helps investors make profits using insider trading data
Conclusion
Monitoring insider trades is crucial because insiders are aware of what is happening within the company, and their actions can suggest future price movements. Reacting to insider signals should be quick, but analyzing SEC’s reports can be time-consuming. Therefore, specialized services that aggregate data on the trades of major shareholders and top executives are the best tools for tracking insider trading. When used correctly, insider information becomes an excellent supplement to fundamental analysis and can help you profit in the stock market.
FAQ
Insider trading refers to the buying or selling of securities by individuals who have access to material non-public corporate information. This includes its employees, executives, auditors, external consultants, and others who have obtained confidential data from them.
An insider is anyone who has access to material non-public corporate information. Insiders may include company shareholders, employees, executives, external consultants such as lawyers or auditors, as well as spouses or friends who have received material information from employees.
Material information is any data that could influence investors’ decisions to buy or sell a company’s securities, leading to changes in the stock price.
Using material, non-public information for stock trading is prohibited and subject to criminal prosecution. However, not all insider trading is illegal. An insider’s transaction is considered legal if the following three conditions are met:
- The insider executed the transaction without relying on material information they possess.
- The transaction aligns with their SEC-approved trading plan.
- The insider submitted their Form 4 trade report.
Data on millions of insider trades is available in the Prismo database. This insider trading analytics platform aggregates data on transactions made by individuals associated with public companies into convenient tables and charts. Prismo’s notifications allow users to track insider buying and selling activities in real time.