Understanding Insider Trading – A Practical Perspective

by Dan

When it comes to insider trading, one of the most fundamental things to understand is that insider trading essentially removes much, if not all, of the risk in investing in a given financial instrument. This amounts to what the SEC (Securities Exchange Commission) views as an ‘unfair advantage.’ Although generally assumed to be illegal, there are times when insider trading can be legal. In these cases, the trades have to be properly disclosed to the SEC. Find out more about this and insider transactions at marketbeat.com. 

Taking it upon one’s self to have a firm understanding of insider transactions amounts to cheating due to the fact that one is engaging in a risky activity with near-certain confidence as to the outcome of a given event. In doing this it becomes possible to gain an edge in the market, but it comes at the cost of other market participants who lose money. It is the zero-sum nature of investing that makes insider trading such a serious act to engage in. Ultimately, it amounts to stealing from other market participants who are addressing the market in a way that is honest.

Information Security and Investing

When it comes to modern instances of insider trading, one of the most obvious dangers in this area is the possibility of data breaches that result in sensitive information being utilized in order to facilitate insider trading. The short and long-term impacts of a data breach can be significant due to a loss of trust, and also potential losses being experienced as a result of information being compromised. When law firms of businesses experience a data breach at a high enough level, there is a strong possibility of insider trading being a potential consequence. It is all a matter of the scope and sensitivity of the information that has been compromised.

Finding the Culprits

It can seem incredibly hard to find and catch individuals who come into possession of such information, but, in fact, one of the easiest ways in which they are caught is via a given lucky streak. If an investor seems to win every single trade they make, it stands to reason that they have an edge that most people are not in possession of. For this reason, many seasoned traders are aware that they must hide their illegal activities with losing trades so as to make themselves appear honest. This is an exceedingly interesting ballet of honest and dishonest conduct that the SEC must grapple with on a regular basis, and this is due to the numbers sometimes not being enough. If someone’s win to loss ratio seems too good to be true, unless it has lasted for a prolonged period of time (years), it is difficult to hold the trader accountable based on this evidence alone.

The Evolution of Insider Trading

The laws and policies governing insider trading have been debated for decades, and this is made evident by a timeline provided by the New York Times in which it is made clear that there have been some significant efforts made to discourage insider trading. In 1909, the U.S. Supreme Court established case law in which a CEO or other authority figure at a given company could not use privileged information to profit from a given investment. While this was a great start, it failed to identify who else might be qualified as an insider and did not necessarily prevent the information from being passed along.

Buying Out Before Cashing In

In 1968, the Texas Gulf case was one in which management at the company and various other authority figures invested heavily in the company’s stock because they knew of a recent discovery of copper that was not made public. Investors were bought out of stock prior to the discovery made public, and once it was, those who had purchased the stock were able to sell it at a profit. 

Both the SEC and the investors who were bought out sued the members of management at the company because it was made clear that they were cheated out of massive potential profits. There was a significant opportunity present in which investors would have cashed in on had they not been bought out, but they would not have sold if they had been made aware of the upcoming copper discovery windfall. 

End of the Road and the Beginning of a New One

In 2016, the New York Times created case law in which those at a given company who come into possession of insider information and pass it along to other parties who utilize it to invest are engaging in insider trading, amounting to today’s definition of the act.

Related Posts