Insider Trading Explained: When Is It Legal and When Is It Not?

Mary Hall serves as an editor for Investopedia’s Advisor Insights and has edited numerous books and doctoral theses. She earned her bachelor's degree in English from Kent State University, complemented by a business minor and a focus on writing.

What Does Insider Trading Mean?

An insider refers to an individual who has access to significant non-public information about a company or owns more than 10% of its stock. This group typically includes company executives and board members.

Key Points to Remember

• Insiders have access to confidential, valuable information or own a substantial stake (over 10%) in a company.
• They are legally allowed to trade company shares but must report these transactions to the SEC.
• Legal insider trading is common, such as CEOs repurchasing shares or employees investing in their employer's stock.
• Illegal insider trading involves exploiting non-public material information for financial gain.
• The SEC monitors unusual trading volumes that occur without public announcements to detect illegal activity.

Understanding Legal Insider Trading

Insiders can legally buy and sell shares of their company or its subsidiaries, provided these transactions are properly disclosed to the Securities and Exchange Commission (SEC) through advance filings. Details of such trades are publicly accessible via the SEC’s EDGAR database.

Examples include CEOs purchasing company stock to demonstrate confidence or employees acquiring shares in their workplace. Warren Buffett’s investment activities within Berkshire Hathaway companies are a notable illustration of legal insider trading.

What Constitutes Illegal Insider Trading?

Illegal insider trading occurs when someone trades stock based on confidential, material information that has not been made public. This can involve company officials, their acquaintances, or even unrelated individuals who gain access to such information.

For instance, if a CEO accidentally reveals quarterly earnings during a haircut and the hairdresser trades on that tip, it qualifies as illegal insider trading. The SEC investigates such cases by analyzing trading volumes that spike without any public news to justify the increase.

Distinguishing Insider Trading from Insider Information

Insider information is privileged knowledge about a publicly traded company that can provide a trading advantage. For example, if a company’s engineering VP overhears that the company missed sales targets before earnings are announced and shares this with a friend who then sells stock early, this is insider information leading to illegal trading.

Trading after the public release of earnings, however, is legal since the information is no longer exclusive.

How to Differentiate Legal and Illegal Insider Trading

Legal insider trading involves transparent transactions by company insiders who comply with SEC reporting requirements. Illegal insider trading involves undisclosed trading based on confidential information, giving an unfair edge over other investors.

SEC’s Role in Detecting Illegal Insider Trading

The SEC employs sophisticated data analytics to detect suspicious trading patterns, especially spikes in volume without corresponding public news. Investigations include reviewing potential access to non-public information and rely on whistleblower reports and inter-agency cooperation to enforce fair market practices.

Who Is Considered an Insider?

An insider is anyone with privileged access to confidential company information, including executives, board members, and significant shareholders owning over 10% of stock. This category can extend to family, friends, or third parties who receive insider tips. Possessing insider status is not illegal; misuse of such information for trading is what constitutes a violation.

Final Thoughts

Insider trading involves buying or selling stocks based on confidential, material information or significant ownership stakes. While many insider trades are legal and properly reported, illegal insider trading exploits undisclosed information for profit. The SEC vigilantly monitors trading activities to maintain market integrity and protect investors.

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