What Investors Can Learn From Insider Trading

It isn't a coincidence that corporate executives seem to always buy and sell at the right times. After all, the CEOs and CFOs of the world have access to every bit of company information you could ever want. However, this doesn't mean individual investors are left in the dark. Insider trading data is out there for all who want to use it. This article will discuss what insider trading is, how we can understand insider trading and where to find insider data on the web.

There are two types of insider trading: legal and illegal. First, let's talk about the illegal variety. Illegal insider trading is the buying or selling of a security by insiders who possess material that is still not public. The act puts insiders in breach of their fiduciary duty. As you can imagine, this is a definite faux pas for anyone closely involved with a company. (For more on insider trading basics, check out Defining Insider Trading.)

A common misconception is that only directors and upper management can be convicted of insider trading. Anybody who has material and nonpublic information can commit such an act. This means that nearly anybody - including brokers, family, friends, and employees - can be considered an insider.

The following are examples of illegal insider trading:

• The CEO of a company sells a stock after discovering that the company will be losing a big government contract next month.
• The CEO's son sells the company stock after hearing from his dad that the company will be losing the big government contract.
• A government official realizes that the company will lose a big government contract, so the official sells the stock.

The Securities and Exchange Commission (SEC) is extremely strict with those who trade unfairly and thereby undermine investor confidence and the integrity of the financial markets. Don't think that those who place the trades are the only guilty ones. If someone is caught "tipping" an outsider with material nonpublic information, that tipster can also be found liable.

There is an important thing to emphasize here: insiders don't always have their hands tied. Insiders legally buy and sell stock in their own company all of the time; their trading is restricted and illegal only at certain times and under certain conditions.

The SEC considers company directors, officials or any individual with a stake of 10% or more in the company to be corporate insiders. Corporate insiders are required to report their insider transactions within two business days of the date the transaction occurred (before the 2002 Sarbanes-Oxley Act it used to be the 10th day of the following month). For example, if an insider sold 10,000 shares on Monday, June 12, he or she would have to report this change by Wednesday, June 14. Changes in insider holdings are sent to the SEC electronically as a Form 4, which details a company's insider trades or loans. The following link is an example of a Form 4 filed by the CEO of Krispy Kreme Doughnuts. A Form 14a, also filed by the company, lists all the directors and officers along with the share interest they have.

This kind of information is extremely valuable to individual investors. For example, if insiders are buying shares in their own companies, they usually know something that normal investors do not. They might buy because they see great potential, a merger, acquisition or simply because they think their stock is undervalued. One of the greatest investors of all time, Peter Lynch, was noted as saying that "insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise." Insiders are prevented from buying and selling their company stock within a six-month period: therefore, insiders buy stock when they feel the company will perform well over the long-term. (Read more about Peter Lynch in our Greatest Investors Tutorial.)

Nejat Seyhun, a renowned professor and researcher in the field of insider trading at the University of Michigan found that when executives bought shares in their own companies, the stock tended to outperform the total market by 8.9% over the next 12 months. Conversely, when they sold shares, the stock underperformed the market by 5.4%. If you're interested in learning more on insider trading, check out Seyhun's book: "Investment Intelligence from Insider Trading."

This is definitely one area of investing that has revolutionized investing. With the click of a mouse, anyone can find the latest insider trade data for just about any public company. Here are a couple of sites that provide insider-trading data for free:

• Yahoo! Finance - Look up any quote on Yahoo! Finance and click on "Insiders" for a list of the latest trades. Some insider trading filings don't appear in databases until a month after the fact, but Yahoo seems to have one of the most current data feeds.
• SEC EDGAR Database - While not visually appealing, this is where trading data is first sent. To find these filings on the SEC website, you must search for the 'central index key' (CIK) for the company. The CIK is used on the SEC's computer systems to identify corporations and individual people who have filed a disclosure with the SEC. Once you have the CIK, you can search for individual filings at https://www.sec.gov/cgi-bin/srch-edgar.

Insider trading data is nothing new. For years, people have been basing their investment decisions on the actions of insiders. While this data is important, just remember that large companies might have hundreds of insiders, which means trying to determine a pattern can be difficult. Continue, as you normally would, to complete your due diligence on a company, but also be aware of what insiders are doing. They probably know more than the rest of us.