Friday, March 21, 2008

Insider Trading Study

Insider trading is buying or selling a company’s stock when you have important inside information about the company that has not been made public. We tend to think of insider trading as being illegal, but that is an oversimplification.

The top executives of a company almost always have inside information. If insider trading were illegal, then these executives could never trade their own stock. In the US, insiders are allowed to create prearranged trading plans, called 10b5-1 plans, for trading stock.

The idea is that the executives can set out a plan to commit to trading stock at particular prices or at particular times. This way, the stock trades will happen automatically when the time comes, and the executive is protected from accusations of insider trading.

Insiders beat the average

But the insiders still seem to outperform other traders significantly. Business Week reported that “Alan D. Jagolinzer, an assistant professor at Stanford University Graduate School of Business, recently completed a study of roughly 117,000 trades in 10b5-1 plans by 3,426 executives at 1,241 companies. He found that trades inside the plans beat the market by 6% over six months. By contrast, executives at the same firms who traded without the benefit of plans beat the market by only 1.9%.”

It is possible that these executives had great insight into the future performance of their companies at the time they set up the prearranged trading plans. But there are other possibilities as well.

Tinkering with the trading plans

According to Business Week, “despite the 'prearranged' nature of the trading plans, executives have enormous flexibility to start, stop, restart, and amend them at will. Some use the plans to trade just once; others use overlapping plans.”

So, it appears that in many cases these trading plans are being abused to allow executives to trade at will in their company’s stock.

The next time you think that maybe you could make a fortune day trading, remember that in addition to trading against other day traders and paying commissions frequently, you may be trading against a company executive who knows what is likely to happen much better than you do.

2 comments:

  1. Another possibility is that insiders set the standard. Insider buying is seen as a sign of confidence in the company and thus the price could rise in the wake of purchases.

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  2. jayjay:

    That could explain a short-term rise in stock prices. But the momentum generated by people believing that insider buying is a good thing would evaporate after a quarter or two if the financial results don't meet expectations. Since the study checked prices after 6 months, I'm guessing that the insider buying by executives reflects genuinely good company performance rather than purely momentum.

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