It's unfortunate, but the publicity around the Martha Stewart scandal has resulted in a misunderstanding of insider trading. In fact, not all insider trading information is bad news for a company, and it can even be useful when researching stocks.
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 trades. Each of these three forms will help the investor to get a better understanding of exactly how this term is defined.
The insider trading definition that follows references individuals required to report their 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.
To summarize, insider trading consists of:
Unfortunately, the term insider trading has come to be associated with illegal activity. 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.
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 the individual's business ethics.
When conducting stock research, the term refers to legal trading activities. For example, corporate insiders such as officers, directors, and employees engaged in buying and selling of stock in their companies.
Using the above definition, it's time to talk about how to interpret the information, and where to find it. As mentioned, Forms 3, 4, and 5 are used to report activities to the SEC. This type of information can be found in the electronic reports section of 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 activities: planned sales and recent transactions. Planned sales are announcements by corporate insiders 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.
The interesting thing about insider trading information is that it can sometimes tell investors 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 the CEO of Company X has a large number of "in the money" stock options, or is holding a lot of shares in the company he or she is running. If that CEO has reason to believe the stock market is placing a relatively high price on Company X's stock, the CEO is likely to be selling.
On the other hand, if that same CEO believes the market is undervaluing Company X's stock, the CEO may be 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, investors are able to understand whether or not the top executives and decision makers in a company think the stock is over or undervalued.
Perhaps one of the more interesting examples of insider trading has to do with Eric Schmidt, the former 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 the sales of stock options cost the company in the area of $200 million. In April of 2006, Google had around $370 million in outstanding employee compensation attributed to stock options. With around 6,700 employees, that works out to an average of nearly $55,000 per employee.
Eric Schmidt was perhaps the most active insider trader of all time. 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 the CEO of Google believes that $400 per share is a price at which he would rather sell stock then purchase it.
This is the kind of logic to use when examining insider trading information. As an investor, it's important to know how activities can be used to augment other information that's been gathered about a company.
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