Insider Trading Definition

Cite this article as:"Insider Trading Definition," in The Business Professor, updated March 20, 2019, last accessed May 25, 2020, https://thebusinessprofessor.com/lesson/insider-trading-definition/.

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Insider Trading Definition

Stock trading by people who have information about securities and stocks that are confidential and not available to the general public is called Insider Trading. Sharing confidential company information with others as well as Insider Trading is illegal in most countries.

The only exception to illegal Insider Trading is when the Directors or Proprietors with 10% or more stake in a company, liquidate their stocks and make this knowledge public via legal channels. The Securities and Exchange Commission has rules and regulations in place to thwart insider trading investments by insiders.

A Little More on What is Insider Trading

The ImClone Insider Trading Case of 2001

In 2001, Peter Bacanovic – a stockbroker at the firm Merrill Lynch shared confidential information about ImClone Systems – a biopharmaceutical company, with Martha Stewart. Word had gotten around that the CEO of ImClone Systems, Samuel Waksal, was liquidating all his stocks in the company due to the FDA’s rejection of their anti-cancer drug, Erbitux. Stewart quickly offloaded her 4000 shares in the company, two days before the FDA’s decision was made public, saving herself losses to the tune of $45,000. Once this information became public, ImClone shares fell by 16%.

Since Stewart’s trading was based on information not available to the general public, she was charged by the SEC with securities fraud and obstruction of justice, in 2003. Although Stewart was neither on the board of the company, not privy to the FDA’s decision, she was indicted for acting on information acquired illegally. Her sentence was reduced after a case in 2004 and she did time at a federal corrections facility.

Amazon Financial Analyst’s Insider Trading Case

Former Financial Analyst at Amazon, Brett Kennedy, was charged with Insider Trading in September 2017. He was alleged to have shared confidential information on quarterly sales with Maziar Rezakhani before the sales records were made public. As per SEC records, Rezakhani paid Kennedy $10,000 for his help in earning profits to the tune of $115,977, trading in Amazon stocks.

References for Insider Trading

  • Continuous auctions and insider trading, Kyle, A. S. (1985). Econometrica: Journal of the Econometric Society, 1315-1335. This journal connects the dots between Insider Trading and Continuous Auctions using a dynamic model of sequential auctions. It examines the impact of confidential information on price fluctuation in a speculative market, showing how prices exhibit Brownian motion.
  • Special information and insider trading, Jaffe, J. F. (1974). The Journal of Business, 47(3), 410-428. This article shows the relationship between Insider Trading by officers, directors, and more, and the consequent gain in profits by a margin of 10% overall, as deduced by studying the trading patterns of over 45 companies indulging in Insider Trading, over a period of six months.
  • The world price of insider trading, Bhattacharya, U., & Daouk, H. (2002). The Journal of Finance, 57(1), 75-108. This book looks at Insider Trading laws in 87 countries off the 103 that have stock exchanges. It examines the cost of equities after the enforcement of these laws and prosecution of fraudulent trading practices.
  • The regulation of insider trading, Carlton, D. W., & Fischel, D. R. (1982). Stan. L. Rev., 35, 857. This book discusses the impact of prohibiting Insider Trading within firms, and its long term effects on the survival of the firm in the capital market.
  • An empirical analysis of illegal insider trading, Meulbroek, L. K. (1992). The Journal of Finance, 47(5), 1661-1699. This book analyses the effect of Insider Trading on day trading practices, using data from Securities and Exchange Commission on illegal Insider Trading. It discusses ways to regulate the stock market against this practice.
  • Merger announcements and insider trading activity: An empirical investigation, Keown, A. J., & Pinkerton, J. M. (1981). The journal of finance, 36(4), 855-869. This paper samples 194 firms that were merged and the pattern of Insider Trading prevalent in their securities data prior to the merger. It sheds light on the pervasive problem of information leakage and its consequences on stock trading gains.
  • Insider trading: Should it be prohibited?, Leland, H. E. (1992). Journal of Political Economy, 100(4), 859-887. This journal approaches the issue of Insider Trading from the other end and makes a case in favour of it with the help of an endogenous investment rational expectations model. It also identifies problems with this model.
  • The walk‐down to beatable analyst forecasts: The role of equity issuance and insider trading incentives, Richardson, S., Teoh, S. H., & Wysocki, P. D. (2004). Contemporary accounting research, 21(4), 885-924. This book takes a look at the various way firms indulge in Insider Trading, focussing on “earning-guidance game” where analysts give inflated earnings estimates, eventually reducing their forecast figures but not before managers and directors have offloaded their shares at a higher price. It sheds light on this symbiotic relationship between analysts and managers.
  • Insider trading in credit derivatives, Acharya, V. V., & Johnson, T. C. (2007). Journal of Financial Economics, 84(1), 110-141. This book does a quantitative assessment of Insider Trading in the credits derivatives market. It finds evidence for incremental information leaks by banks, especially concerning negative news about credit and other trading entities, that subsequently suffer a fall in prices.
  • Market efficiency and insider trading: New evidence, Rozeff, M. S., & Zaman, M. A. (1988). Journal of Business, 25-44. This book looks at facts and figures concerning Insider Trading information that rank outsiders are able to benefit from, and the impact on the efficiency of the market due to these anomalous transactions.
  • Fraudulently misstated financial statements and insider trading: An empirical analysis, Summers, S. L., & Sweeney, J. T. (1998). Accounting Review, 131-146. This study examines the relationship between fraud and Insider Trading. It draws interesting insights based on empirical data from companies that indulge in Insider Trading and their fraud risk assessment.
  • Corporate control, insider trading, and rates of return, Demsetz, H. (1986). The American Economic Review, 76(2), 313-316. This book outlines the relationship between Corporate Control, Insider Trading, and the profits so gained by looking at investment and holdings data from 511 firms.

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