Insider trading typically refers to either trading on insider information or the buying and selling of shares by company insiders -- top management, key employees and investors -- who are privy to confidential information and have sizable stakes in the company. Despite the negative connotation, not all insider trading is illegal.
Trading on insider information is illegal because it puts other investors who are not yet aware of a certain development at a disadvantage. A company is required to disclose material information that can impact the stock price to all investors at once; it cannot favor one group over another. It is unfair when somebody benefits from information that causes others losses or deprives them of reasonable profits. In addition to negative financial ramifications for investors, trading on insider information undermines public trust in the company linked to it.
Trading on Insider Information
Not all trading on insider information is done by insiders. An insider can leak the information to an institution or a group of investors who will act on it ahead of other investors and share the benefits with or return the favor to the source later. An outsider who comes into possession of insider information and acts on it may be found guilty of illegal insider trading.
Supposed that XYZ, a small biotech company, is on the verge of getting its new potent drug approved by the Food and Drug Administration (FDA). When the news of the approval is announced, the biotech stock may double in price, jumping from $5 to $10 per share overnight. Insiders are fairly certain that the drug will be approved so they buy the stock at $5 right before the announcement and sell it at $10 after the announcement, essentially doubling their investment virtually risk-free overnight. Regular investors who were not privy to the information may have sold the stock at $5 prior to the FDA approval and were shortchanged on their profits, or had to buy it at $10 after the approval and were deprived of the profit.
Or suppose that ABC, an equipment manufacturer, loses a big customer. The loss will negatively impact earnings so the stock price is likely to drop on the announcement. Prior to the announcement, some insiders sell at $50. After the announcement, the stock drops to $35, causing all other investors $15 per share in losses.
Insiders must report their stock sales to the Securities and Exchange Commission. Most insider sales are legal: many insiders have a substantial amount of their assets tied up in company stock and may want to sell to take profits or to diversify their holdings. It's excessive insider selling that concerns investors. Insiders know their companies better than anybody else so if they are selling aggressively, it suggests trouble. Massive insider selling may depress the stock price and encourage other investors to sell. Things look even worse when insiders publicly praise the virtues of their company while privately selling the stock.