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What is Insider Trading and how could it affect your investment?

Your capital may be at risk. This material is not investment advice.

You may have come across the term “insider trading” when reading articles about the financial industry. When this event occurs, it can have an impact on a company’s stock price. But what is it? And how does it affect investors? In this article, we will discuss the answer to these questions, and many others.

What is Insider Trading?

In many countries insider trading is a crime, but the laws that govern it differ greatly from one another, as do the consequences of a conviction.

Perhaps the easiest way to explain this concept is through an example.

Insider Trading Example
Several days before Company X releases its annual results, one of its directors reveals to a friend that Company X has performed well above expected, exceeding all expectations for annual earnings.

If this friend then buys shares in Company X, with the expectation that upcoming results will cause the share price to rise, before this information is made public, they would both be guilty of insider trading.

Even if the manager in our example inadvertently revealed the information or accidentally left the information in a place where it could be read, he would still be thoroughly investigated and possibly charged.

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How do you discover people using inside information to invest?

People buy and sell individual stocks every day during the opening hours of the stock market. So, how do you find insider traders simply by placing transactions in the stock market?

Financial markets are highly regulated and there are teams of people whose main job is to keep an eye on the markets, looking for anything suspicious or out of the ordinary.

When a publicly traded company makes an announcement that affects the price of shares, it is very likely that these people will return to the stock market before the announcement and look for any unusual transactions that may set off alarms.

Going back to the example from the previous section, once our investor realized that Company X’s annual results would likely cause his share price to rise, he buys $ 100,000 worth of Company X shares, before the report is published.

If a market regulator sees this large transaction conveniently completed just before the annual results are announced, he is likely to take action and investigate. If his investigation found that this investor was related to one of the directors of Company X, they would have reason to intensify their investigations.

Likewise, if they saw a major transaction from someone who never invests, or who usually invests in small sizes, that would raise suspicions.

So, if you have friends or family who work for publicly traded companies, and from time to time you may receive insider, non-public information that could influence the stock price, don’t be tempted to buy or sell! actions based on this information!

Why is Insider Trading Illegal?

Simply put, insider trading is illegal because it is considered unfair to investors who did not have access to the crucial information on which the transaction was made.

Organizations like the Securities and Exchange Commission (SEC) in the US and the Financial Conduct Authority (FCA) in the UK oversee the financial markets and try to maintain a level playing field.

There was a time when insider trading was completely legal in most markets. So thinking evolved to consider it a “victimless crime.”

But imagine selling a long-term stock to an insider, right before an announcement that causes the share price to rise dramatically, and think for a moment about how you would feel (you probably wouldn’t have sold if you knew the same information and you could have made high profits). Now it is more obvious that it is not really a victimless crime.

Can "insiders" buy shares?

Company directors, employees and people close to both groups are free to buy and sell shares in the company in question, however in developed markets such as the UK and the EU, they must declare their operations to the authority. competent. If they are later found to have been in possession of non-public price information, they will be investigated.

Who is considered an "insider"?

“Insiders” are not just the people who work within a particular company. The rules apply to other people, outside the company, who come across sensitive financial information: bankers, fund managers, lawyers, accountants, etc.

A few years ago there was even a case of an insider circle centered on a print shop. It was a specialized printing company that often handled sensitive documents such as annual reports and financial prospectuses. One of the employees realized how valuable the information was and organized a group of people around him to take advantage of it. Everything worked fine, until they got caught.

Why is it important for investors to understand the meaning of “Insider Trading”?

You are probably thinking “What does this have to do with me? I am not the director of a publicly traded company and I do not have access to any non-public information that could benefit my investments.”

Although this may be the case, a problem with insider trading is that it not only results in hefty fines and possible prison sentences for accomplices, but it can also have a negative effect on the actions of the company involved.

Next we are going to see an example of how this situation affects the market. You can see prices in real time with the MetaTRader 5 trading platform, it is free, so download it in a few seconds!

Amazon: Insider Trading Example in Action

➤ On September 28, 2020, the SEC charged a former Amazon CFO and two members of his family of insider trading. This reportedly occurred between January 2016 and July 2018, resulting in earnings of approximately $ 1.4 million.

➤ On November 5, 2020, the husband of the former Amazon financial manager pleaded guilty to the charges. When the market opened the next day, November 6, indicated by the vertical red line in the chart below, Amazon’s stock price fell more than 2% to $ 3,248.11.

The stock price recovered most of its losses for the day and closed at $ 3,308.91. However, when trading resumed on Monday, November 9, Amazon’s stock price opened at $ 3,124.44. A fall of more than 5.5% over the weekend, as seen in the gap. The share price continued its downward trajectory the following day.

Can I use this information to my benefit?

Unfortunately, as with many pivotal events, by the time you become aware of insider trading convictions, as a shareholder, it could be too late to take action.

However, for those who are not shareholders, a conviction for “insider trading” can represent an investment opportunity.

If you are interested in buying shares in a company and an insider use case involving that company is later prosecuted, bad press will likely cause the share price to drop.

▶ A smart investor, who considers something like a temporary embarrassment to the company and believes that the stock will surely rally, could take advantage of the stock price drop.

Going back to our Amazon example, if we had bought shares just before the market closed on November 10, 2020, it would have cost about $ 3,045, compared to $ 3,320 the day before the plea was announced in the case of use of inside information.

Final thoughts

There are opponents of insider trading remaining an illegal activity, citing other industries in which people can freely benefit from superior knowledge than their counterparts.

However, as we have seen, for good reasons, insider trading in the investment world is illegal in many countries, and market regulators strive to ensure that financial markets remain as fair as possible to all. interested.

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NOTE: This article is not an investment advice. Any references to historical price movements or levels is informational and based on external analysis and we do not warranty that any such movements or levels are likely to reoccur in the future. In accordance with European Securities and Markets Authority’s (ESMA) requirements, binary and digital options trading is only available to clients categorized as professional clients.
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