What is insider trading?
What is insider trading? It’s a type of investing that is often highly illegal because governments see it as exploiting an unfair advantage.
Insider trading has negative connotations in most jurisdictions because most people see it as a harmful practice compromising a fair market based on good-faith investing.
The whole truth is more complex; insider trading is usually illegal; other times, it is legal if it conforms to specific local laws.
What is insider trading?
It occurs when someone trades stock public stock based on information that only they (and perhaps a select few others) know about.
It has been common throughout corporate history. It can also yield enormous windfalls for anyone with insider knowledge and vast losses for those without.
For those reasons, many countries have banned the practice out of concern that it destroys fair market principles. In other words, the inside information should either not be acted on or made public before action is taken.
In some circumstances, insider trading is legal, but governments often carefully define when.
What classifies insider trading?
Usually, two crucial components:
- The information used to trade must be material to investors. Not every piece of company information matters in investing, but anything that does matter is considered material. Investors use this information to shape whether they buy or sell securities. In other words, it affects the price of stock.
- The material information must be non-public. It is legally confidential, known only to a select few in the company (usually senior figures) and anyone outside the company they choose to tell, whether they’re entitled to or not.
Where are there laws against insider trading?
As a rule of thumb, assume your jurisdiction has some kind of law against insider trading because it is widespread.
For example, the US, EU, Australia, India, South Africa and the UK have legislation inflicting criminal penalties on insider traders.
Moreover, most jurisdictions take insider trading very seriously, so don’t expect a guilty party to land a light fine. Heavy financial penalties and prison sentences can await anyone caught doing it.
Why should corporate leaders care about insider trading?
Confidential knowledge reigns at senior levels
Boards, executives and management are the most likely to know company information that could drastically alter investment patterns if released. They are also very likely to have shares in the company themselves.
In short: insider trading often begins at this level.
Insider trading laws usually target anyone involved
Take this example:
A company director knows their firm’s share price is about to decrease rapidly – it’s a bear market, and the last quarter’s earnings have been terrible.
The director doesn’t sell their own stake, but they do convey that information to their spouse before quarterly earnings figures are released.
Then, the spouse conveys the information to a friend with shares in the company. The friend sells their stake. The share price plummets the following week.
Many jurisdictions will hold the director, the spouse, and the friend equally guilty in such situations.
The penalties are significant
In the US, for example, anyone found guilty of insider trading can be fined up to $5 million and face up to 20 years behind bars. That’s how seriously major global economies take this practice.
Is insider trading ever legal?
Yes. In fact, it occurs regularly, although what is allowed depends heavily on jurisdiction.
Legal insider trading allows directors and senior management to act on information without compromising fair-market principles.
Usually, it involves making the trade and then reporting it and the people involved to a national watchdog. For example, this would be the Securities and Exchange Commission in the United States.
By flagging the trade immediately (and we mean immediately), insiders are often deemed to have made enough information known to the market regulator, thus satisfying a need for it to be public.