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What Is Insider Trading (Explained: All You Need To Know)

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What Is Insider Trading?

What’s important to know about it?

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Let me explain to you what insider trading is and why it’s important!

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What Is Insider Trading

Insider trading is a term used to refer to a person selling the shares of a publicly traded stock on the basis of important and non-public information.

In other words, the person trades stocks while having material “insider” information on the particular stock.

Insider trading is generally viewed as something negative or a type of crime.

However, insider trading can be legal depending on when the person trades the stock while having material.

An insider can trade the stocks of a company while having insider information to the extent he or she complies with the Securities And Exchange Commission’s rules.

The reason why insider trading is tightly regulated is to ensure that individuals who have access to non-public information do not “profit” from that information by buying or selling stocks for a profit.

For instance, a company executive knowing that the company has done really well in the past quarter may want to buy shares of the company before its financial statements are released.

This way, upon release of the company’s financials, the insider executive will profit from the rise of the stock’s price.

Keep reading as I will further break down the question of what insider trading means and how it works.

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How Does Insider Trading Work

Insider trading refers to the act of buying or selling stocks while having access to important and internal information about the stock in question.

Anyone trading shares while having access to material and non-public information will be considered executing an “insider trade”.

However, to the extent the insider complies with the SEC rules on insider trading, the transaction will be viewed as lawful.

On the other hand, if the insider trades stocks without following the SEC rules, the trade will be considered illegal and result in significant fines, penalties, and consequences.

The way insider trading works is that a person must first have access to “material information” that is not available to the market and the public investors which can impact an investor’s decision to trade the stock.

If the information is not legally available to the public and is important enough to impact an investor’s decision to buy or sell the stock, that information will be considered insider information.

Now, a person who has access to insider information can potentially buy or sell stocks while having an unfair advantage over all other investors in the public.

As a result, the SEC makes the practice of insider trading illegal to ensure that all investors are able to make buying or selling decisions without giving anyone any unfair advantage.

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Insider Trading Example

Let’s look at an example of insider trading to better understand the concept.

Insider trading is when a person buys or sells stocks of a company while having access to material and non-public information that could affect an investor’s decision to buy or sell.

The most classic example of insider trading is a company CEO knowing how well or poorly a company is doing based on the company’s internal and confidential financial data and buying or selling stocks before the financial information is made public.

In essence, the CEO used “insider information” to his or her advantage while all other market participants did not have access to the same depth of information.

Another example of insider trading is when a company insider provides another person with material and non-public information leading that other person to profit by trading the stock.

In this context, the company insider and the third party will be held responsible for violating insider trading rules as the insider tips off a third party leading that person to earn a profit.

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Insider Trading SEC Rules

When someone trades stocks in compliance with the SEC rules while having access to insider information, the transaction will be considered legal.

For an insider to trade a company’s stock, he or she must disclose the transaction to the SEC in a timely manner and make an announcement on the company’s website.

For example, an insider in a large public company who is looking to buy or sell shares of the company will need to electronically notify the SEC of the transaction and issue a press release on the company’s website providing details on the transaction.

The SEC rules require that company directors and major stockholders disclose their stock holding in the company, notify the SEC of all their transactions on their stocks, and provide details on any change in ownership.

There are different forms that can be used to make different types of disclosures to the SEC.

The SEC Form 3 is used by someone to disclose his or her stock position and holdings in a company.

The SEC Form 4 is used to notify the SEC of a buy or sell transaction on the stock.

The SEC Form 5 is used for transactions that have been done earlier or deferred transactions.

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What Is Insider Trading FAQ

When will insider trading be illegal?

Insider trading will be illegal when someone trades a particular stock while having “material” and “non-public” information on that stock that would have impacted an investor’s decision to buy or sell shares.

In other words, insider trading will be illegal if someone tries to use privileged information, confidential information, or any type of non-public information to gain an unfair advantage when trading securities.

However, not all insider trading will be considered illegal.

Those that comply with the SEC rules can lawfully execute insider trades.

What is the punishment for insider trading?

If a person is found guilty of insider trading, he or she can be exposed to a fine or even sent to prison.

A conviction of insider trading can expose the defendant to a maximum fine of up to $5 million and imprisonment of up to 20 years.

Insider trading will be legal to the extent the person trading the stocks complies with the rules set out by the SEC.

The SEC’s objective is to ensure that market participants and all investors can trade securities fairly and on a level playing field.

As a result, to the extent an insider discloses his or her holdings, transactions, and change in ownership, the stock trade will be deemed legal.

What are some examples of insider trading?

Here are some examples of situations that could be considered as insider trading:

  • A company employee or executive trades the stock on the basis of important insider information
  • A company employee or executive provides information to family and friends about the company who end up trading shares based on this information
  • An employee of a brokerage firm or investment banking company trades shares based on confidential information received from a company while on the job
  • A government employee having confidential information on a company trades stocks for a profit
  • A person misappropriated a company’s internal information and traded shares of the company

How does the SEC define illegal insider trading?

The SEC defines illegal insider trading as follows:

Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, on the basis of material, nonpublic information about the security. Insider trading violations may also include “tipping” such information, securities trading by the person “tipped,” and securities trading by those who misappropriate such information.
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Takeaways 

So there you have it folks!

What does insider trading mean?

In a nutshell, insider trading is the act of buying or selling securities of a publicly-traded company while having material and non-public information on the security in question.

Material information refers to any information that can have a substantial impact on an investor’s decision to buy or sell shares.

Non-public information refers to any information related to a company that is confidential and is not legally made public by the company.

Quite often, the notion of “insider trading” has a negative connotation as it is used to refer to when corporate executives, directors, and major shareholders trade stocks while having access to the company’s internal information.

However, to the extent a person trades shares of a company by following the SEC rules, insider trading can remain lawful.

In the course of US history, you’ve had people like Martha Steward, Joseph Nacchio, Yoshiaki Murakami, Raj Rajaratnam, Brett Kennedy and Maziar Rezakhani were found to violating insider trading rules.

Now that you know what insider trading means and how it works, good luck with your research!

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Author

Amir K.
Hello Nation! I'm a lawyer by trade and an entrepreneur by spirit. I specialize in law, business, marketing, and technology (and I love it!). I'm also an expert SEO and content marketer. On this blog, I share my experience, knowledge, and provide you with golden nuggets of useful information. Enjoy! Feel free to connect with me on LinkedIn.

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