It’s all over the news and can get people in a lot of trouble, but what exactly is insider trading? The answer may surprise, especially since it isn’t always illegal.

What is Insider Trading?

In a nutshell, insider trading happens when a person uses non-public information to decide to buy or sell a security. Many cases are made against executives or employees of a corporation who receive advanced knowledge of stock activity before it is made public, or against lawyers, fund managers, accountants, or anyone who has access to official documents before they are released to the public.

The information has to be material, which often refers to early leaks of documents to be released to shareholders or to the general public. These trading documents often share information about the company’s performance, which could influence investors’ decision to buy or sell the stock. When an insider trader has advanced access to the documents, they can use that knowledge to make a trade or purchase before anyone else know what is happening.

Insider trading can happen in a variety of situations. Examples include a pharmaceutical company having success in its last phase of trials for a new drug. The release of the drug would be a huge boost to the company’s stock price after it is released to the public.

understanding the rules of insider trading

However, if a company employee sees the memo announcing the trial’s success before it is released, they could use that information to buy shares of the security while it is still at a lower price before the public hears the news and buys the stock, which will drive the price up.

Insider trading can also happen with advance knowledge that a stock price is about to drop, such as if a CEO scandal is about to break. People with advance documents of the event could sell their shares quickly and still cash in the higher price before the news goes public and the stock plummets.

Insider trading is monitored by the Securities and Exchange Commission (SEC). It is illegal when insiders pass on advanced information to friends and colleagues. Many companies have systems in place to prevent illegal insider trading, such as blackout dates that prevent employees from trading their stocks of the company around big announcements and regular compliance training to alert employees of the effects and consequences of insider trading.

When is it Legal?

Though insider trading is often illegal, there are legal scenarios. Legal insider trading occurs when corporate insiders, such as directors or employees, trade securities issued by their own company.

Any time a corporate insider buys or sells shares of his own company, the information must be disclosed and made public by the SEC. These insiders can only trade securities of their own company during times when there isn’t any material, non-public information that could affect the trading decision.

As long as the buying or selling information is disclosed to the SEC and made public according to regulations, insider trading is considered legal.

Why Does it Matter?

Financial markets stay strong when all investors are honest. Insider trading can hurt the system because it gives some people a distinct advantage of information that other investors don’t have, which takes away the inherent risk of trading for the insiders and leaves it for other investors.

This can cause investors to lose confidence in the market and could potentially lead to a crash. Insider trading also robs investors of seeing the full value of their securities because prices are inflated or cut short before they have a chance to grow to their full potential.

Trading from the inside

However, there are also arguments in favor of legal insider trading. The practice reflects all information in a security’s price instead of just the public information, which makes the markets more efficient.

Another line of thought proposes that insider trading is simply delaying the inevitable—a stock will eventually rise or fall when public information is released, but allowing insiders to make trades earlier simply alerts investors to a change in the company while they still have time to let it affect their stock decisions.

The pro-insider trading arguments ultimately boil down to the fact that it takes a lot time and resources to enforce insider trading regulations, when that time could be better spent.

No matter where you fall in your thinking of insider trading, it is an important process to be aware of for all investors. No matter if it is illegal or not, insider trading affects the market and is definitely something to watch for.

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Note: The opinions expressed in this article are the author's own and do not necessarily reflect the view of Alvexo on the matter.