What Is Insider Trading and Why Is It Illegal?

‘’The most valuable commodity I know of is information’’. Does anyone remember this quote from Oliver Stone’s 1987 movie Wall Street? The main character, Gordon Gekko, makes millions of dollars from insider trading. What is insider trading exactly? Stock markets are supposed to be a place where everyone has the same opportunity to make money. However, certain individuals often take advantage of non-public material information. How does insider trading happen and how can we limit it? Let’s find out.

What Is Insider Trading

Insider Trading

As we established earlier, insider trading is done when an individual trades stocks based on non-public material information.

This information can be directly about a company, industry, or the economy in general.

The 2012 STOCK Law was set to prevent members of Congress to use non-public material information to their benefit. Below are a few examples.

Sources of Insider Information

Company executives and staff will know ahead of time if material information will affect the price of a stock; insider trading.

If they choose to act on it before it becomes public, they’ll be in breach of the laws and regulations set by the SEC.

Which news can affect stock price movement positively or negatively?

Earnings Above or Below Expectations

If revenues or EPS figures substantially differ from analyst predictions, the stock price may have major swings in both directions. 

Mergers and Acquisitions

Sometimes, it may take months for two companies to agree upon a deal to merge or sell their business. It can be difficult to keep that information secret for that long. Before the deal is finalized, people in the know can time their trade to take advantage of the situation.

Raising Capital

When companies issue stock in exchange for capital, the price will often drop. Individuals can short the stock accordingly and profit from the news.

Legislation

When Congress passes some laws that will benefit certain sectors or open the economy to new products, many people know which companies will benefit. It becomes easy for them to buy stocks that will be affected by the news. 

Economic Data

Economic data such as the unemployment rate, inflation, and interest rates can dictate the course of the stock market for an extended period of time. Recently, we learned that inflation was above the 2% benchmark we seek yearly.

Stock markets plummeted due to this news. The same goes when the unemployment rate rises monthly or when interest rates increase. Investors have less confidence in the economy and the stock market.

Before this news become public, those with prior knowledge can act on it and take advantage of the stock market. A 2020 study showed that about 15% of insider trading in the US is identified. 

Stopping Insider Trading

As with all crimes, it’s essential to limit and stop them. Insider trading may seem like a petty crime, but it affects the lives of many. The stock market is no longer a free market if some people can manipulate it for their personal gain.

The true price of a security is not reflected due to insider trading and the general public can lose confidence in the market. Many laws are in place to stop this, but they don’t seem to work. 

Examples of Insider Trading

During the early days of the pandemic, many US politicians bought and sold stocks in unprecedented ways. Many were given information about possible lockdowns and the effects of COVID before the general public.

The same pattern was present when certain companies received favorable rulings during the pandemic. Of course, it wouldn’t be fair for a ban on all trading for politicians.

However, politicians should report all their trades. Furthermore, there should be enhanced enforcement on the motives to buy or sell a certain security.

Now, we will take a look at scandals in recent years involving insider trading.

Insider Trading: Martha Stewart (2004)

Martha Steward spent a few months in jail because she sold all her shares of a biopharmaceutical company, ImClone Systems. She received a tip that one of the top-level executives sold all his shares. This was not public material information. Shortly after, the FDA rejected their drug and the stock lost 16%.

Insider Trading: Steven Cohen and SAC Capital (2016)

Steven Cohen and his not bankrupt hedge fund paid $135M in settlements and $1.8B in penalties for insider trading. There appeared to be tons of evidence of wrongdoing.

However, Cohen only received a slap on the wrist and avoided jail time altogether. He bribed banks for early information about certain companies and demanded shady information from his employees. 

US Rep. Chris Collins (2020)

New York congressman Chris Collins spent 25 months in jail and paid a $200K fine for tipping his son over a failed drug trial for a pharmaceutical company. This is a perfect example of a congressman taking advantage of a situation. 

More US Politicians

Insider Trading

Many current senators and politicians are under investigation over trades performed during the COVID era.

Just recently, 57 congressmen failed to properly disclose their trades under the 2012 STOCK Act. There’s currently a proposal for the complete ban of trading for members of Congress. I wonder how many are against it for personal reasons.

Fun fact: Nancy Pelosi’s (D-California) husband, Paul Pelosi, was often accused of insider trading. He owns an investment firm and made big money from tech companies.

Coincidentally, Nancy Pelosi is supposed to regulate them. Anyways, the creator of r/WallStreetBets created a fund that mimics the Pelosi stock activity. If you can’t beat them, join them. The fund trades on the MERJ exchange in Seychelles and is only available to users of the WallStreetBets app.

There is a big difference between insider trading and informed trading. Many investors perform very good due diligence and research before purchasing a security. Some believe they are trading based on crooked information, but they are just better at finding and analyzing the information than others.

Insider Trading Conclusion

For some reason, I really enjoy crooked hedge funds and politicians being punished for corrupting the stock market. If you’re like me, maybe the movie I mentioned at the very beginning (Wall Street) will be your next watch.

At the same time, I’m sure that if you’re gven some juicy news about a stock, you might not hesitate to pull the trigger. Nonetheless, it’s better to be an informed trader than an insider trader. Keep doing your due diligence and analysis before purchasing a security.

If you want to learn more about how you can profit from the stock market, head on over to our free library of educational courses. We have something for everyone, including trading options for those with small accounts.

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