Insider trading is the act of making financial trades based off of information that is not
openly available to the public.
For example a CEO buying shares in their own company because they know that the business
is about to publish record profits would be insider trading.
Once this report becomes available to everybody more people will want to purchase the stock
increasing the price and making the CEO a healthy profit with very little risk.
It doesn’t even need to be a CEO.
Sometimes even entry level analysts are privy to potentially market moving information,
at the end of the day, it’s not going to be the CEO writing up quarterly reports.
This can create opportunities for people to make more than their annual salary by simply
buying up some call options and waiting for their report to go public.
Someone with a consistent flow of insider information on a single publicly traded company
could easily make triple figure annual returns which could make even an investment of a few
thousand dollars turn into millions very quickly.
The problem is, that this practice is illegal.
I think most of you already knew that.
But, should it be?
It was only actually outlawed in 1934, and back then it was only done to stop company
executives taking advantage of the market turbulence of the great depression.
So what’s the harm?
How does one executive making a bit of money equate to everybody else loosing money?
Especially since they are making those trades with willing counter parties who would have
traded those stocks with someone else if not for them.
So it’s time to learn how money works to find out if insider trading laws actually
achieve anything, and to see why the abolishing these laws could lead to more efficient and
stable markets in the long term.
Again I find myself making a video on literal financial fraud which is obviously not very
advertiser friendly, fortunately I can keep making these video’s thanks to the support
I receive from my channel members and patrons on Patreon, so thank you guys.
…
The tricky thing about insider trading is knowing exactly where to draw the line.
There are extreme cases which are obviously illegal, such as the rogue ceo or analysts
that we used as an example at the beginning of this video but some are harder to say for
sure.
I should add at this point of the video that I am not a lawyer, so don’t be going and
telling the SEC that I said any of this was legal or illegal.
Even if I was a lawyer it’s impossible to say for certain where the line is drawn in
a given case, which is actually part of the problem.
Consider this example.
You walk into a five star restaurant and you are sat next to a CEO and a CFO of a large
public company.
The pair get a little drunk and start talking openly about how big their bonuses are going
to be once their annual sales figures are releases to the public.
This sounds like good news so the next day you buy up shares in their company and sure
enough a week later once quarterly profits are made public the stock rallies 20% based
off of the promising figures.
Is this insider trading?
On the surface it looks to be, you had access to information that wasn’t openly available
to a general member of the public.
You used that information to make an informed financial decision and you profited off of
doing so.
Even if this isn’t insider trading for you, would it count as insider trading for the
careless CEO who indirectly divulged this information?
Well… actually… no, it would not, that’s because even though the average investor would
not have been lucky enough to come across the information you gathered by being sat
next to these two loud mouths, it was still announced to the public albeit in a very limited
forum.
Ok but what about if those tables were pushed together, suddenly the CEO the CFO and you
were all having dinner together and the same conversation took place.
Then that would be insider trading because you would be deemed as someone personally
selected by an insider to have access to a forum where market moving information is discussed.
Well ok, what happens if we assume the CEO and CFO are strangers in a restaurant again
and we are just sitting next to them.
Instead of discussing a annual profits they are discussing a corporate that they are planning
to announce the next week.
You buy up stock in the company they are planning to take over and once again the value of the
stock rallies and you make a healthy profit.
Sounds the same as the first example right?
You just happened to overhear something in a public place.
Well this unfortunately would be insider trading because information regarding mergers and
acquisitions is held to a higher standard by the SEC and there is the reasonable expectation
for all marker participants that this information is not public until it is formally announced.
Let’s consider another slightly morbid example.
You are the member of a very prestigious golf club, you are hanging out on the 10th hole
when you see a very influential CEO of a public company fall dead of a heart attack on the
11th.
After (hopefully) calling an ambulance you open up Robbin hood and short the stock of
that company?
Would this be trading on insider information?
I am actually going to let you all discuss that one in the comments section, I need that
video engagement, but don’t worry we will work it out together by the end of this video,
you know I wouldn’t leave you guys hanging like that.
Alright, final hypothetical here.
Let’s say you and your sister were math and science prodigies growing up.
Your used her talents to become the CEO of a fortune 500 tech company.
You on the other hand used your talents to try an beat the markets as a day trader.
You never trade on any information your sister, or her associates share with you but you do
trade stock in her company as well as other competing companies since technology is the
field that you know best.
your high performance arouses suspicion from the SEC and both you and your sister are charged
with insider information.
How do you prove you are innocent?
The legal burden of proof lies with the prosecutors, but by that time she might have lost her job
and brokers may decide not to work with you.
Hopefully you can see through all of these examples that drawing the line of what insider
trading is, and is not, is incredibly difficult.
In reality no two parties ever have access to identical sets of information when making
a trade.
A regular investor looking at Robinhood on their phone is not going to have access to
the same information as a managing director on a Goldman Sachs trading floor.
Artificially just restricting some people from making trades simply makes something
called price discovery slower.
Price discovery is the process of markets slowly finding the ideal price for an asset
through people selling it when the price is too high or buying it when the price is to
low.
In theory having a market price which is perfectly realized means that the price would be truly
indicative of the underlying value of the asset.
It might sound like financial jargon but imagine if you could buy and sell shares knowing that
the price on offer is perfectly fair based on all information.
It sounds great but regulation against insider trading as well as other laws that hold back
trading activity prevent that from ever being perfectly achievable…
…
Now price discovery and legal grey areas are far from the main argument coming from supporters
of insider trading.
Those issues pale in comparison to the fact that insider trading happens all the time,
and it’s practically impossible to stop at least 50% of it at minimum.
This is not some rant about how the SEC is underfunded or anything like that, even if
the agencies in charge of cracking down on this kind of behavior had all of the money
and manpower in the world, they could still not stop 50% of insider trading.
This is because of what is called omitted trades, or trades that insiders choose not
to make.
Let’s think back to our humble analyst again putting together a company report which is
going to deliver some kind of good news to shareholders.
Because they are not deemed important enough in the corporate hierarchy, they do not need
to publicly disclose their trades nor do they need to plan them ahead of time like the senior
executives do.
Well let’s say that this analyst was trying to decide if they should sell the shares that
they were given as part of their bonus last year.
Once they start working on the report, they realize that these shares are going to be
worth a lot more in just a few weeks so they instead decide to hold onto them to wait until
they are worth more money and reassess what to do then.
This is making trade decisions based on insider information
The reverse is also possible.
If an analyst WAS going to buy shares in the company they work for but then change their
mind because they start working on a report that is going to deliver very bad news then
this too is making trading decisions based off non public information.
This is technically illegal and it’s why senior executives in America need to declare
their trading plans months in advance, but unless you extend this requirement to all
employees or start prosecuting literal though crimes it’s impossible to stop this happening
amongst every other insider in the business.
…
So insider trading helps markets operate efficiently while being almost impossible to police and
difficult to prosecute.
Why do these laws exist then?
Who does insider trading actually hurt?
Well it’s not good enough to just say “regular investors” because that’s not actually
true.
Insider trades need to be made with a willing counter-party.
Nobody is holding a gun to the head of a regular investor and forcing them to sell their shares
to a corporate insider.
The regular investor and the insider agree on a price that they are both happy with.
The regular investor on the other end of this trade would have no way of knowing who that
person was, and they wouldn’t magically be any worse off as compared to a reality
where they just sold their stock to another regular investor.
People holding the stock wouldn’t be any worse off either.
If the company is about to announce good news, then they will do well, if the company is
going to announce bad news then they will do poorly.
A few insiders trading on this news before it goes public is not going to change the
inevitable.
On the contrary these insiders might make the decline in price more gradual avoiding
some of the emotional trading that can be caused by public announcements.
Alright in the interest of fairness there is one legitimate issue cause by insider trading,
and that is that it can stifle market activity.
To demonstrate this in a simple way imagine that you had a stock market with only two
participants, yourself and some corporate insider that knows everything going on in
all of the companies listed on the exchange.
Now consider this insider puts up an offer to buy some of your shares.
Would you sell them?
The logical answer is no, because this insider is only offering to buy those shares because
they know they will be worth more soon based on some kind of information they have but
you don’t.
As with all of these examples the same is true in reverse.
If they offer to sell you shares you should not buy them because they are only going to
offer to sell you something if they know it’s going to be worth less in the future.
This would cripple market activity and make it impossible for anybody to accept any trade
without loosing out to an insider.
Except it probably wouldn’t.
In a market with just two participants sure, but in a market with millions of participants
and no way of telling who is an insider and who isn’t, this really wouldn’t be an
issue.
There would be one group that would miss out however, and that is the speculators.
People (or much more commonly institutions) that make trades based of a stock being undervalued
or overvalued would find it much harder to make profitable these trades successfully
in a market where price discovery was more efficient.
Would it be worth loosing hedge funds and day traders in exchange for knowing that the
stocks we buy are not going to be drastically altered by some report sitting on a desk somewhere?
I’ll leave that up to you to decide.
Now if you are still thinking about making a trade as the golfing CEO gets shipped off
to the morgue then fear not, what you did was morally reprehensible but perfectly legal.
If you enjoy moral reprehensibility in the name of profit then you will love my video
detailing exactly how Jordan Belfort made his million in the wolf of wall street.
Thanks again to my channel members and patrons on Patreon for making it possible for everybody
to keep learning how money works.