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Insider trading is an often misunderstood investing tool. It can be helpful for traders, but its value is very often overstated.
This is a good topic to tackle right now as we are seeing almost twice as many insiders buying in November and December of 2008 than any other month over the last year according to Insider-monitor.com. From a certain perspective this could indicate that insiders are becoming a little more optimistic about the market’s prospects in the near term.
Who Are These Guys?
Insiders are technically classified as anyone with material non-public information. Usually this means 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 those restrictions is reporting requirements. Because insiders must report their trades to the Securities and Exchange Commission, 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, or if they are buying, then they must be optimistic. On average, stocks with high insider buying does show some correlation with a rise in price, however, selling does not appear to be reliably predictive.
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Why They Buy
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 predictive.
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 video below, 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.
John Jagerson is a contributor to LearningMarkets.com. To learn more about him, read his bio here.
This article originally appeared on the Learning Markets Web site.
