An Inside Look at Insider Trading—Part One

02/24/2009 1:20 pm EST

Focus: STOCKS

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

Insider trading is an often misunderstood investing tool. It can be helpful for traders, but its value is usually overstated. This is a good topic to tackle right now as we are seeing an uptick in the number of insiders buying in late 2008 and early 2009 compared to the last year. This could indicate that insiders are becoming a little more optimistic about the market's prospects in the near term.

Insiders are technically classified as anyone with material non-public information. Usually this means employees, officers, directors, or shareholders who own more than 10% of the company's stock. Insiders can trade their own stock but have certain restrictions on how, when, and how much they can sell or buy. Part of these restrictions include reporting requirements.

Because insiders must report their trades to the SEC, ordinary investors can get access to that information and can see what insiders are doing. It makes some sense to assume that if insiders are selling stock, then they are pessimistic about the company, but if they are buying, then they must be optimistic. On average, stocks with high insider buying do show some correlation with a rise in share prices, however, selling does not appear to be reliably predictive.

Peter Lynch famously said "Insiders might sell their shares for any number of reasons but they buy them for only one: they think the price will rise." This statement seems reasonable and may be a good explanation for why insider buying is more predictive than selling. There have been many studies on the topic of returns and insider trading and one notable example suggests that a diversified portfolio of stocks with high insider buying outperformed large stock indexes by as much as 9%. This justifies some time and attention paid to the subject.

In the next article, I will dig into some more of the detail around insider buying and how traders can implement strategies around insider buying within their own portfolio.

In the video, I will cover the definition of insider trading and show an example of the impact that this activity can have on a stock's price.

Click here to watch the video.

By John Jagerson, of PFXGlobal.com and LearningMarkets.com.

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