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It's unfortunate, but the publicity around the Martha Stewart insider trading scandal has resulted in a real misunderstanding of insider trading. In fact, not all insider trading information is bad, and it can even be useful when researching stocks.
Insider Trading Defined
The Securities and Exchange Commission has established strict reporting policies, or requirements, around the reporting of insider trading activities. In fact, the SEC has three different forms that are used to report insider trading. Each of these three forms will help the investor to get a better understanding of exactly how insider trading is defined.
- SEC Form 3 is really the first form that needs to be filled out by any newly appointed corporate insider because this form registers a person as an "insider." This is the form that is used to register the shares of stock held by those required to report insider trading activities.
- SEC Form 4 is used to report insider trading transactions to the SEC. Any change in stock ownership usually must be reported to the SEC within two business days of a transaction.
- SEC Form 5 is used to report any transaction that was not reported on Form 4, or a transaction that was eligible for deferred reporting.
The insider trading definition that follows references individuals required to report insider trading activities. Corporate insiders are defined as company officers and directors, as well as any beneficial owners of more than ten percent of a class of the company's equity securities, registered with the SEC.
So to summarize, insider trading consists of:
- A registered list of corporate "insiders"
- Current stock trading transactions, or activities, of these insiders
- Registered / deferred stock trading transactions of these insiders
Illegal and Legal Insider Trading
Unfortunately, the term insider trading has come to be associated with illegal trades. This is due primarily to high profile cases such as Martha Stewart's March 2004 conviction that was based on her trades of ImClone stock.
Illegal Insider Trading
When people talk about illegal insider trading, they are usually referring to the buying or selling of a security based on nonpublic information. Corporate insiders have a fiduciary duty, or a relationship of trust, when they are in possession of information that could materially affect the price of a stock. This is why trading stocks based on this type of information is considered illegal, as well as an important test of one's business ethics.
Legal Insider Trading
When conducting stock research, we use the term insider trading to refer to legal insider trading activities. Legal insider trading is simply corporate insiders such as officers, directors, and employees engaged in buying and selling of stock in their companies.
Stock Screeners and Insider Trading
Now that we understand what insider trading is, it's time to talk about what the information means, and where to find it. As mentioned, the SEC Forms 3, 4, and 5 are used to report insider trading activities to the SEC. You can find this type of information right in the electronic reports found on the SEC website.
Generally, all stock screeners report insider trading information. Stock screeners are arguably the best place to find this kind of information, and since the data is reformatted, it is easier to browse through.
Stock screeners report two kinds of insider trading: planned sales and recent transactions. Planned sales are announcements by corporate insiders that they plan to sell or buy stock at a future date. Transactions are a retrospective look at the buying and selling patterns of stocks by insiders.
Evaluating Insider Trading Information
The interesting thing about insider trading information is that it can sometimes tell us about management's overall sentiment concerning a company's future prospects versus the current value of a share of the company's stock.
For example, let's say that the CEO of Company X has a many stock options, or is holding a lot of shares in the company he or she is running. If that CEO has reason to believe that the stock market is placing a relatively high a price on Company X's stock, then the CEO is likely to be selling stock.
On the other hand, if that same CEO believes the market is undervaluing Company X's stock, you might see that CEO purchasing shares of Company X.
Of course there are exceptions to these rules, for example, the CEO might be selling shares of stock to purchase a small island in the South Pacific. But just like all investors, corporate insiders sell shares when they think the price of their stock is high, and buy when they think it's low. By examining these patterns of stock purchases and selling, you can get a feel for whether or not the top executives and decision makers in a company think the stock is over or undervalued.
Google and Insider Trading
Perhaps one of the more interesting examples of insider trading has to do with Eric Schmidt, the CEO of Google. At one time, GOOG was selling for nearly $400 a share and had a P/E ratio of around 69 - which is quite high by any standard.
In 2005, Google reported that the sales of stock options cost the company in the area of $200 million. In fact, as of April 2006 Google has around $370 million in outstanding employee compensation that can be attributed to stock options. With around 6,700 employees, that works out to an average of nearly $55,000 per employee.
Eric Schmidt is perhaps the most active insider trader today. On April 27, 2006, he conducted a total of 28 transactions, selling 460,000 shares of GOOG worth a little over $193 million.
Certainly with the sale of $193 million in stock, just enough money to buy that small island, it is not unreasonable to conclude that the CEO of Google believes that $400 per share is a price at which he would rather sell stock then purchase stock.
This is the kind of logic you want to use when examining insider trading information. As an investor, you should now understand how insider trades can be used to augment other information you've gathered about a company. In fact, we're also going to take a look at stock ownership to see how that information can help us to understand the market's feeling about a particular stock.
About the Author - Insider Trading Information
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