Imagine you are playing poker, and you are the only one at the table who knows what cards are coming next. That would give you a massive and unfair advantage. It is the same on the stock exchange. That is why we have strict rules for how people with secret information (insiders) can trade stocks.
"There is nothing hidden that will not be revealed. Truth carries within itself its own protection."
— Florence Scovel Shinn
Just as in the quote, the secrets of the stock market always come to light. When financial authorities discover that someone has cheated by using hidden information, there are severe penalties, including prison.
Legal vs. Illegal insider trading
- Illegal insider trading: This happens if the CEO of a company knows they just lost their biggest customer, and hurries to sell all their shares before the company sends out a press release. He saves his own money, while regular investors take the loss.
- Legal insider trading: This is when the CEO (or board members) buys or sells shares in their own company during periods when there are no secrets, and immediately reports the trade to the stock exchange. This information is then published so everyone can see it.
Valuable signal: Monitoring legal insider trading can be a fantastic strategy! If the CEO and CFO of a company suddenly use their own savings to buy shares in the business they work for, it is a strong signal that they have firm belief in the future.
Pros and cons of following insiders
Advantages (of following legal buys)
- Insiders know more about the health and prospects of the company than any analyst on Wall Street.
- Insiders can sell for many reasons, but they only buy for one reason: They believe the price is going up.
- It is completely free and open to everyone to read insider notices on the stock exchange website.
Disadvantages
- Even top executives can be wrong about the future of their own company.
- An insider sale does not necessarily mean a crisis. Maybe the boss is just selling shares to afford a new cabin or pay taxes.
- It is strictly illegal to trade on tips you get from a friend who works in the company, if the news is not public!