What is Insider Trading?

Published by Thomas Herold in Investments, Laws & Regulations, Trading

The term 'Insider Trading' is included in the Investments edition of the Herold Financial Dictionary. Get yourself a copy now on Amazon - available as Kindle or Paperback.

Insider trading is a generally negative phrase, though it can also refer to a legal activity. The illegal and better known version if it involves a person purchasing or selling a security when they have information that is not publicly available on the stock. The timing involved in such a trade often determines if it is legal or illegal.

If the critical information has not yet been released to the public, then it is not legally allowed. This is because the government determined to level the playing field in investing. Trading securities when investors have special knowledge is not fair to those traders who do not have the ability to access this information.

A person who tips off other individuals is also participating in illegal insider trading. This is the case if the tipster possesses valuable and relevant information that is not available to the public. Fines and jail time can be given to those who pass along illegal insider information. The responsible body for policing this type of illegal trading is the SEC Securities and Exchange Commission. They maintain and enforce rules that protect average investors from the results of illegal insider trading.

Legal insider trading happens all the time. It is not as well known as the illegal version. A legal trade from an insider occurs when company directors buy or sell shares that they fully disclose according to the rules. This occurs every week. The transactions must be electronically turned in to the SEC in a manner that is timely. Not only must they be sent in to the SEC, the company of the person involved must disclose this transaction information on their official website.

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Congress passed the Securities Exchange Act of 1934 to address this issue. This first important step pertained to company stock transactions and legal disclosure. Major owners of securities and directors of the company as well had to disclose their positions, any transactions, and any time the ownership changed hands.

Several forms allow corporate insiders to legally disclose their stock affairs. Form 3 permits them to initially file that they have a company stake. Directors use Form 4 to make a disclosure on company stock transactions two days or less after the sale or purchase. They utilize Form 5 for earlier transactions or for transactions that become deferred until later.

It is not only company or corporate directors who are able to be tried and convicted for insider trading. Stock brokers and their clients can also be accused of this crime. Martha Stewart is a classic example of a brokerage client who the courts found guilty for placing insider trades back in 2003.

Martha Stewart received a tip from her Merrill Lynch stockbroker Peter Bacanovic concerning her shares of ImClone, a bio-pharmaceutical company. She used this information to sell her shares. Her broker had obtained this information that the Chief Executive Officer of ImClone Samuel Waksal liquidated all of his position in the corporation.

Waksal learned that the Food and Drug Administration was not going to approve his company’s cancer drug Erbitux. After the two sales occurred, the FDA officially and publicly rejected the ImClone treatment drug. This caused a major selloff in the company stock of 16% in a single trading day. Stewart had saved a stock loss of $45,673 by selling out early.

The problem was that her sale had been based on the tip that CEO Waksal had sold all of his shares. This had not been publicly disclosed. Waksal became convicted and received a seven year jail sentence. Martha Steward was also convicted and forced to serve out five months in jail. She also received a number of months of house arrest and then probation.

The term 'Insider Trading' is included in the Investments edition of the Herold Financial Dictionary. Available now on Amazon in Kindle and Paperback.