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Finance 101: What is Insider Trading?

Many times, it happens that the senior-most officials of the company have access to such information about the company that if leaked to the general public can bring major fluctuations in the prices of company’s securities.

Insider Training refers to the practice of trading in securities by a person who has some confidential or sensitive information about the company which is not available to the public in general. If a person is in a position to access such confidential information about the company and he deploys such information to trade in the company’s security, it amounts to insider trading.

The things that will be discussed in the article include:

  1. Who is an Insider?
  2. How does Insider Trading Happen?
  3. Kinds of Insider Trading
  4. How is Insider Trading Detected?
  5. Prosecution for Insider Trading
  6. Precautions to Avoid Insider Trading

Let’s cover each of the things step-by-step.

Who is an Insider?

In general terms, insider refers to the directors or other senior officials of a publicly-traded company. It also takes in its ambit those individuals and entities who are beneficial owners of more than prescribed percentage of the total shares of the company carrying voting rights.

From the perspective of insider trading, the definition of an insider also includes any such person who makes use of sensitive information about the company which is not available in the public domain, to trade in the company’s securities.

To check whether any information is public or not, you can refer to websites like Motley Fool and Algo Signals, which help a user to stay updated about the latest news related to listed companies.

How does Insider Trading Take Place?

Normal trading takes place on the belief that all the market participants have equal access to market information and they make use of the skills to make technical analysis and gain profits out of their trades. However, when you get hold of such material information about a company that is not available to the rest of the public, it gives you an advantage over the others. You may have gained this information either because you work in that company or because someone from the company leaked out this information to you. When you acquire such information it becomes your fiduciary duty not to make personal gains from it. But when you breach this duty and invest in the company’s securities based on the unpublished information, you give rise to insider trading.

Kinds of Insider Trading

There are two types of insider trading, namely legal insider trading and illegal insider trading.

Legal Insider Trading

Not all insider trading is illegal. There is no restriction on the insiders to trade in the securities of the company of which they are an employee. However, such transactions are required to be reported and registered with the regulatory authorities such as the Securities and Exchange Commission (SEC) in advance.

Examples of legal insider trading include CFO of the company selling the company’s shares held by him or the employees of the company purchasing or selling the shares of the company.

Illegal Insider Trading

Illegal insider trading happens when some material unpublished information relating to the company is misused by a person who breached his fiduciary duty. The officials of a company have a primary duty not to misuse the confidential information that they gather about the company in their benefit. But when they misuse the information by either trading themselves in the company’s securities with a motive to earn profits or passing the sensitive information to others before the information is officially published, it amounts to illegal insider trading. A Person who passes the information to another person is known as a tipper and a person who receives such information is known as a tippee.

How is Insider Trading Detected?

A huge number of transactions take place daily on the stock exchanges. Then how are the regulatory authorities able to track down the transactions relating to insider trading?

The authorities follow stringent monitoring practices to get an idea about possible insider tradings. Securities markets are closely monitored with the help of advanced tools to detect any abnormal trading pattern. Once such abnormal patterns are identified, the authorities make inquiries from any such person that they suspect. The authorities can even call for financial records to collect evidence.

Sometimes, insider trading is disclosed through tips as well as complaints, which is a rare case. In case you come across any suspicious pattern, you can refer to TradingView, to make use of charting tools to better analyze the patterns, and when you gain certainty about the possibility of insider trading you may report to the authorities. Once the authorities have enough evidence against any person, they may hand over the person to the police authorities.

Prosecution for Insider Trading

You can be prosecuted for insider trading, only if the following allegations are found true against you:

  • You have traded in the security.
  • You had access to material information about the security or the company.
  • Such information was not available to the public.
  • The information was material in the sense that had it been available to the public, it could lead to price fluctuations.

All these charges when found true amounts to insider trading. As a result, the following consequences can arise:

  • You can be subjected to a jail sentence.
  • Penalty may be imposed in the form of a fine.
  • You can be forced to surrender the amount of gain that you earned or the loss that you avoided. The amount that you might be required to submit may be multiple times of the gain earned or loss avoided.
  • Other consequences include loss of reputation, loss of job, high fees for defending criminal cases, and so on.

Precautions to Avoid Insider Trading

You may end up indulging yourself in insider trading without any intention to do so. Here are some things to keep in mind to ensure you don’t accidentally carry out insider trading.

  • If anyone provides you any information about a company, search for the information on the public forums. If the information is not available on public platforms, it hints towards insider news and you should restrain yourself from dealing in securities of that company.
  • Further, when you get such information from anyone that is unpublished information, you should report the same to regulatory authorities. Doing this will save you from any legal trouble afterward.
  • When you inquire about security make sure you draft your questions in such a way that it doesn’t give out such an impression that you are asking for sensitive information. You would not want to be blamed that you asked for such information!
  • Even if you don’t trade in the security based on material unpublished news about the company, but you pass on the information to others, you will be guilty of insider trading. So, it is better not to pass on any such information.

Conclusion

Insider trading is being viewed as a very serious offense in all jurisdictions. Therefore, you should ensure that you don’t indulge in any such act which could give rise to insider trading. Whether you do it intentionally or accidentally, it will still be an offense. So, it is important to take precautions so that you don’t accidentally get involved in such an act.