The Relationship Between Insider Trading And Stock Prices

For the average person, hearing the term "insider trading" typically evokes images of hazy boardroom meetings, secret whispers from the mouth of an executive to the ear of his trusted associate, who would then go and trade on the information just received. Later, the associate returns the favor by sharing some of the profits of the illicit trade with the executive, perhaps by slipping a swaddled brick of cash into his hands during a back-alley walk-by.

While some illegal activity does occur, the term "insider trading" refers to all transactions of corporate insiders of their own firms. The SEC and Justice Department hardly challenge many of these, hence, most if not all of them are assumed to be legal. Any time the aforementioned executive buys or sells the stock of his own company, that is an insider trade. That insider could be an officer, director, or a large shareholder. In trading the shares of their own companies, the insider is subject to significant regulation, including the requirement to report the trade to the Securities and Exchange Commission within two business days of the transaction, not to short the company stock, not to make any profits from a round trip trade shorter than 180 days, and to not trade while in possession of material, non-public information.  The subsequent analysis relies on these reported, regulated transactions and therefore assumes they are legal.

As insiders are highly informed about their own firms, their trades can and do send signals and result in after effects as investors trade the stock on that perceived information. This begs the question:

How exactly does insider trading affect the stock price of the insider's firm?

In order to answer this question, we should first consider why insiders might trade their own stock. If an insider is in possession of some confidential information that will cause a price reaction in either direction once revealed (usually more than a few months out), they can profit by beating investors to that trade. If insiders only traded for this reason, one would expect most if not all insider trades to cause price reactions upon being revealed, provided the trade itself was revealed before the confidential information used to make the trade. 

However, in addition to trading on information, insiders may also trade for liquidity reasons. Even if they possess no material, confidential information, an insider may still decide to sell shares if he needs cash, or buy shares to use up excess savings. This sort of trade doesn't communicate information that would warrant a subsequent price reaction. It is not possible to glean from news of any single insider trade whether that trade was conducted for information reasons or liquidity reasons. 

Hence, any one single insider trade should not affect the stock price too much. 

Evidence shows that stock prices in fact move abnormally about 0.10% on the trade date in the direction of the insider trade. This is a bit too small for investors to trade on.

But that doesn't mean that there is too little information in insider trades in general. But first, a discussion of the kind of information that insiders are actually allowed to trade on is needed.

Both public legislation and private guidelines govern the type of information that can be traded on as well as how insiders can legally trade their own stock. As mentioned earlier, the SEC requires insider trades to be reported in a timely manner, within two business days of the transaction. Insiders also avoid trading immediately before information disclosures in their own firms (8-Ks). They typically trade one to three months in advance of any disclosures. Furthermore, there may be another delay before the news of the trade is made available to the public. Additionally, any profits made on two trades that occur within 6 months of each other must be returned back to the corporation. Finally, what is explicitly outlawed is the trade on "material, nonpublic" information. While what constitutes material and nonpublic information is left to a judge to decide, the classic example is trading immediately prior to corporate disclosures such as earnings announcement, dividends, takeovers, or corporate restructurings.

In addition to public regulations, many corporations themselves have rules in place regarding the trades of their top executives in order to promote fairness and transparency.  Firms have defined blocks of time where trading is not permitted - usually any time before one or two weeks following the quarterly earnings announcements. These are referred to as "blackout" periods.  Firms have compliance officers that will prevent insiders from trading on material news inside these blackout periods.  This ensures that insiders are not able to trade on the information contained in the earnings announcement immediately before the news arrives. Together, these rules prevent insiders from taking blatant advantage of information which would otherwise present them with a low-risk, high-profit trading opportunity.

So what kind of information are insiders actually allowed to trade on? Insiders can trade on public information outside of the blackout periods as well as on the basis of their long-term outlook for the firm. Given their positions and involvement in the firm, insiders are well-informed about developments within their industry and how their firm's product will evolve with the market given forward-looking macroeconomic and technological trends and changes in consumer preferences. They can safely trade on this information without worrying about violating any laws, because they are not trading on nonpublic information in this instance, but rather they are utilizing their expertise that comes with experience in their role in a particular sector of the economy.

Now that we have discussed what kind of information insiders are allowed to trade on, we can move on to answering the question at hand. How and how much does insider trading affect stock prices? From our earlier discussion, we learned that because insiders may trade for reasons that both would and would not justify a price reaction, any individual trade does not affect the stock price much per se. However, getting multiple signals from multiple insiders is highly valuable and more reliable.  A further extension of this idea is aggregation over an industry, sector and the entire stock market.  As more insiders trade in the same direction, the quality and the precision of the information improves and allows for better trading opportunities.

A better question to ask then, is does insider trading predict future stock returns, and if so how much?

If our theory is correct, then insiders should be able to leverage their expertise and firm-level knowledge to make profitable, legal insider trades by beating investors to the punch. Meaning, purchases by insiders should be followed by increases in the price of the stock, and sales by insiders should be followed by decreases in the price of the stock. These changes in the price of the stock following insider trades should occur at a magnitude greater than expected.

In fact, this is exactly what professor Nejat Seyhun found in his classic investigation, "Investment Intelligence From Insider Trading" (MIT Press, 2000). By categorizing months for each firm as "buy" or "sell" months, Seyhun then examined the subsequent 12-month return following "buy" or "sell" months, net of the stock market. Between 1975 and 1994, stock prices rose by 4.5% net of the market following "buy" months from insiders, and fell by 2.7% net following "sell" months, for an average spread of 7.2%. While not a risk-free strategy, this finding appears to be robust when examining each year individually. This suggests that on average, insider trading is able to predict stock prices as insiders are able to trade profitably on average. Hence, insider trading has information content at the firm-specific level.

Evidence by Professor Seyhun also shows that aggregating insiders trades over industry, sector and the market further improves the information content of insider trading. Insiders do not need to be able to predict the future in order to trade profitably. They are able to anticipate the effect of macroeconomic developments on their own companies and make profitable trades in the process. For example, the current rising interest rate environment has many nervous about a potential recession, especially since Federal Reserve Chairman Powell recently announced a 75 basis point hike and signaled continued rate increases into 2023. Insiders are best suited to connect the dots and calculate exactly how rising interest rates will likely affect their firm given their knowledge of their firm's debt structure, profitability, and so on. Hence, these insiders will come to a better conclusion faster than outside investors and will be able to trade profitably. This is why there is an information advantage to be had in following aggregate insider trading, where investors from all firms and industries are constantly making the same calculation for their own firms, the sum of which is reflected in the aggregate figures. 

While "insider trading" may carry with it a certain pejorative connotation, there is much to be gained from analyzing legal insider trades. Since any one insider trade could be due to a number of factors, individual trades will not have a large affect on the stock price. However, collections of insider trades are more highly informative. Insiders face regulation from public and private spheres governing how they can trade their own company's shares and therefore will make trades based on the general outlook for their firm, competitive environment, and how they anticipate macroeconomic, technological and consumer trends will interact with their company given their knowledge of firm-specific characteristics. Because of this, insider trading doesn't affect stock prices in and of itself immediately, but insiders react more quickly to information on these developments and therefore insider trades will predict the greater stock market activity both at the individual firm level as well as industry, sector, and market levels over the subsequent three to six month time horizon. 

If you found the above content informative, you may be interested in the new service we just launched in collaboration with Professor Seyhun. Intended for money managers, day traders, and investors of any size, insidersentiment.com tracks aggregated insider trading indicators for a variety of investment styles and can help you stay ahead of the market.