Investments, tenth edition

  Insider Trading 

 Regulations also prohibit insider trading. It is illegal for anyone to transact in securities 

to profit from  inside information,  that is, private information held by officers, directors, 

or major stockholders that has not yet been divulged to the public. But the definition of 

insiders can be ambiguous. While it is obvious that the chief financial officer of a firm is 

an insider, it is less clear whether the firm’s biggest supplier can be considered an insider. 

Yet a supplier may deduce the firm’s near-term prospects from significant changes in 

orders. This gives the supplier a unique form of private information, yet the supplier 

is not technically an insider. These ambiguities plague security analysts, whose job is 

to uncover as much information as possible concerning the firm’s expected prospects. 

The dividing line between legal private information and illegal inside information can be 

fuzzy. 

 The SEC requires officers, directors, and major stockholders to report all transactions 

in their firm’s stock. A compendium of insider trades is published monthly in the SEC’s 

 Official Summary of Securities Transactions and Holdings.  The idea is to inform the public 

of any implicit vote of confidence or no confidence made by insiders. 

 Insiders   do  exploit their knowledge. Three forms of evidence support this conclusion. 

First, there have been well-publicized convictions of principals in insider trading schemes. 

 Second, there is considerable evidence of “leakage” of useful information to some trad-

ers before any public announcement of that information. For example, share prices of firms 

announcing dividend increases (which the market interprets as good news concerning the 

firm’s prospects) commonly increase in value a few days  before  the public announcement 

of the increase. Clearly, some investors are acting on the good news before it is released 

to the public. Share prices still rise substantially on the day of the public release of good 

news, however, indicating that insiders, or their associates, have not fully bid up the price 

of the stock to the level commensurate with the news. 

 A third form of evidence on insider trading has to do with returns earned on trades by 

insiders. Researchers have examined the SEC’s summary of insider trading to measure 

the performance of insiders. In one of the best known of these studies, Jaffee  

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    examined 

the abnormal return of stocks over the months following purchases or sales by insid-

ers. For months in which insider purchasers of a stock exceeded insider sellers of the 

stock by three or more, the stock had an abnormal return in the following 8 months of 

about 5%. Moreover, when insider sellers exceeded insider buyers, the stock tended to 

perform  poorly.      

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6/18/13   7:44 PM

6/18/13   7:44 PM

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  How Securities Are Traded  

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