Insider Trading 101: A Short Course on Insider Trading

This is a short course covering the basics of insider trading. All investors are strongly encouraged to read this page, since even intermediate investors may not be familiar with all the topics discussed here.

What is Insider Trading?

Insider trading is when individuals/institutions that typically have access to non-public information about a company engage in trading that company's stock or derivatives.

Imagine the CEO of Amazon buying shares of AMZN. Or the president of Visa selling his shares of V. Both of these are examples of insider trading.

However, the term "Insider" extends far beyond just presidents and CEO's. In fact, all of the company's officers, directors, many employees, certain stock holders and even their family members can be considered "Insiders". If you are the CEO's wife, and he regularly vents to you about issues in the company, then clearly you have access to information that the public does not, hence making you an insider.

Is Insider Trading Illegal?

A common misconception is that all insider trading is illegal. That is false, only certain types of insider trading are illegal. What determines whether an insider trade is illegal or not is whether the insider used "Material Non-public Information" to make the trade.

Material Non-public Information

Material Non-public information is any information, inaccessible to the public, that can reasonably be expected to affect the price of a company's stock. This can be anything from a pending lawsuit, revision of earnings, product announcements etc. As long as company insiders have the information and the public don't, the information is considered material.

A couple of days after the information is made public (through a press release for example), the information is no longer considered "material non-public".

Illegal Insider Trading

It is illegal for insiders to trade using material non-public information. The SEC regularly investigates suspicious trades and brings lawsuits against insiders deemed to violate the rules. Both civil and criminal charges can be brought against those engaging in illegal insider trading.

Legal Insider Trading

On the other hand, many insiders want to own/buy shares of their company. Suppose a CEO believes in the long term prospects of the company. He wants to invest in it, and reap the fruits of his labor over the years. Can he do that legally?

The answer is yes. In fact, many companies encourage insider ownership by their officers, employees, directors etc. The important thing is that purchases/sales of securities should not be based on material non-public information to avoid violating insider trading laws. Furthermore, the insider should comply with SEC reporting requirements by promptly filing a Form 4.

SEC Form 4

Insiders who trade a company's stock must file a Form 4 with the SEC, which includes details about the transaction (dates, amounts, prices, etc). The Form 4 must be filed relatively quickly, within only two business days of the transaction. Hence by tracking Form 4 submissions we can get an updated view of insider ownership and trades of a stock.

HedgeFollow's Insider Trading Tracker tracks all Form 4 submissions and processes updates within minutes. Furthermore, you can build your own tracker by following stocks and then heading over to my tracker.

Rule 10b5-1 Trading Plans

A common way for insiders to have an affirmative defence to insider trading liability is to make use of Rule 10b5-1 of the Securities Exchange Act of 1934. The basic idea is that an insider adopts a predefined trading plan, say to purchase stock over a certain period of time.

As long as the insider did not have material non-public information at the time of adopting the plan, and as long as the insider does not deviate from the plan, leaving a third party to take care of its execution, then the insider would be protected from violating insider trading laws.

Many CEO's and high ranking insiders opt for trading plans because they regularly come across material non-public information. By having a trading plan in place, then even if the trade occurs when they have material non-public information, they are protected from liability as long as they did not have the information when they adopted the plan.

Types of Insiders

As mentioned earlier the term "Insider" covers a broad range of people that typically have access to material non-public information.
The SEC distinguishes the following types of insiders:
  • Officers: Includes the CEO, CFO, COO, CIO, etc.
  • Directors: Includes all directors of the company
  • 10% Owners: Includes individuals/institutions that own 10% or more of a company
  • Other: Includes other types of insiders
Notice that the above groups are possibly overlapping. You can have someone who is both a director and 10% owner. Thus a single insider may have multiple flags corresponding to those groups.

At HedgeFollow, we list all applicable flags underneath each insider's name for each trade. Furthermore, we add a separate additional flag for "CEO", which allows users to distinguish the CEO from other officers.

Types of Insider Transactions

There are many types of insider transactions besides just purchases and sales. The SEC uses various transaction codes and flags to differentiate between them.
At HedgeFollow, we group insider transactions into the following easy-to-understand categories:
  • Buys/Sells: These are purchases/sales of shares by insiders.
  • Buy Plan / Sale Plan: These are also purchases/sales of shares, but in this case the transaction is part of a trading plan. We discussed trading plans in an earlier section.
  • Tax Liability: Insiders commonly sell stocks to cover tax (or other type of) liability.
  • Award: Insiders are often awarded stock as part of compensation.
  • Gift: Insiders sometimes receive stocks as gifts from family members or others.
  • Derivative: Insiders sometimes acquire/dispose stocks as part of a derivative transaction such as option exercise, conversion of stock units, etc.
  • Change of Control: A change of control transaction typically involves large acquisition/disposition of stock to transfer control to another party.
  • Will/Inheritance: Occasionally an insider receives stock as part of distribution of a deceased person's estate.
  • From/To Trust: Sometimes a person might make a transaction with trusts belonging to children or other family members.
  • Disposed to Issuer: This is when an insider returns stock to the company (also called issuer of the stock)..
  • Other: There are various other types of insider transactions that do not fall under the above categories.
The above list is not comprehensive, but covers the most common types of insider transactions. Anyways, most investors are only concerned about buys/sells.

Informative Trades

In the previous section we learned about various types of insider transactions. It was clear that buys/sells would probably be the most interesting to investors.

However, are all buys/sells informative? What about automated buy/sell plans? Clearly these trading plans are not as informative as conscious realtime decisions of an insider to buy/sell stock. What about other buys/sells excluding trading plans? Are they all informative?

We argue that the answer is no.

What is an Informative Trade?

At HedgeFollow, we go much further to distinguish what we consider as informative trades.

Generally, we classify a trade as informative if all of the following hold:
  • It is a Buy/Sell
  • It is not part of a 10b5-1 trading plan
  • It is not redundant
  • It is not overreported
  • It is not for tax liability purposes
  • It has a net positive/negative effect on insider holdings
There are various reasons that can cause a trade to break some of the above rules. For eg. trades between entities owned by same person, trades between husband and wife, etc.

Of course we can't catch them all, but HedgeFollow is definitely the best informative classifier among all websites out there.

Informative Buys vs Sells

Unfortunately, even among informative trades, it is often expected that insider sells will outweigh insider buys.

This is because stock options/grants/awards/etc are built into the compensation packages of many insiders, hence they tend to build significant ownership of shares in the company. Many insiders choose to cash out some of the shares they own over time, for various reasons ranging from diversification to personal needs. Therefore you will find that stock sales exceed stock buys for the majority of companies.

For this reason, insider buys are generally considered more important than insider sells. There are exceptions to this of course, but investors are typically more interested in the purchase side of insider transactions.

Notable Insider Buys

The years have given us many examples of significant insider buys that raised eyebrows and took the spotlight.

One of the biggest was Jamie Dimon's purchase of more than $25M of JPM stock in early 2016. It was very significant for a CEO to put that much money into a stock he already owns so much of. The stock doubled within 2 years, and this remains a notable example of a CEO taking advantage of a stock price that dipped too much.

But insider buys can also bolster confidence in the stock. More recently, David Risher, the CEO of Lyft, bought over $1M worth of LYFT stock. He said he wanted people to see he has skin in the game, and that he expects this "to be very successful".

Regardless of the motives, insider buys remain one of the most heavily watched metrics of any stock.