Using Insider Trading Information as Part of Your Investment Strategy
Corporate officers and members of the board of directors have deeper insight into a company's operations than any outside analyst could ever hope to attain and are skilled businesspeople. It's not a stretch to say that insiders are some of the best-qualified people in the world to evaluate a company's future prospects. Quite simply, they are the smart money.
If you're looking for companies to invest in, why not start with ones that have leadership so confident of future success that they're literally putting their own money where their mouth is? No insider buys a stock thinking that its price will go down — they do so to make money.
There is only one reason to buy
Anyone who buys a stock on the open market does so because they expect the price to rise - no one invests to lose money and insiders are no exception. There are two main reasons why insiders would invest in their own companies they believe:
- business is about to get better, or
- the company is undervalued.
Whatever the reason for insider buying, outsiders only need to know only one thing: insiders think that the company stock price will go up.
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The profitability of following insiders has not escaped some of the top investors of our time. Peter Lynch included insider buying as one of his famous 13 attributes of a "perfect" company in his investing guide One up on Wall Street, and Christopher Browne, a successful value investor, used insider trading as a key point in his stock picking strategy. Now the information and tools these guys have been using for years are available to all investors.
Analyzing Insider Buying and Selling
With thousands of insiders reporting transactions each day, what are the companies that you should be focusing on? While we can't arrange personal meetings with top company leadership to ask them directly how confident they are, we can infer their overall sentiment by looking at their buying and selling behavior.
Understand which insiders are making trades
When researching insider trading activity at a company, first look to see who is doing the purchasing. Not all insiders are created equal, and identifying the best insiders to follow will help you prioritize the companies to investigate further. When evaluating a purchaser, take a look at their:
- Position: While all insiders are well-qualified to evaluate a company's future prospects, take a close look at purchases made by top executives (e.g. CEO, COO, CFO, etc.). These C-Level officers have the most comprehensive insight into a company and are the company's most skilled and experienced businesspeople. Members of the board of directors and other corporate officers (Vice Presidents, etc.) also have deep insight into a company's operations.
- Historical performance: Look also at how insiders have performed with their past purchases. Some insiders are better than others at identifying and taking advantage of situations where the market has temporarily undervalued their company. An insider who has a strong performance on a number of past purchases is likely to perform well on a recent purchase as well.
Understand the insider's commitment
When investors are more confident in a company, they're willing to commit larger amounts of money to it. When evaluating an insider's sentiment about their company, take a look at:
- Dollar amount: Insiders invest more so that they can make more when they are confident of the company's future prospects. Small or regular purchases that can be attributed to retirement plan contributions or participation in an employee stock purchase program can be disregarded, and are not indicative of bullish behavior.
- Change in total holdings: For those insiders who are not multi-millionaires, even a relatively small purchase can significantly increase their personal holdings. This significant increase in holdings signals a strong confidence in the company and the insider's correspondingly bullish outlook.
Understand the company's insider sentiment
While any purchase by an insider is a vote of confidence in that company's future it is important to understand what other company insiders have been doing. If multiple insiders are showing bullish signs, you can be more confident in that company's future. When evaluating overall company sentiment at a company, take a look at:
- How many insiders are purchasing: When two or more insiders are buying at the same time, it shows that a consensus of opinion has formed in the company regarding its future prospects. This reduces the chance that any one insider has misinterpreted data and increases the likelihood that the stock price will rise.
- What the overall trend has been: Insiders sell their own stock far more often than they buy it because they receive a large part of their compensation in the form of options and/or grants. However, if insiders are selling less than they historically have, this may send a signal a change in sentiment about the company's future prospects.
There are a number of factors that investors can weigh against each other to effectively use insider trading data, which may seem like a daunting task at first. Our Insider Sentiment report presents the most promising companies to you as determined by their insider trading activity to help you uncover investment opportunities. You can then use our powerful insider trading search and reporting tools to analyze our suggestions.
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Q Who are insiders?
A The term "insider" is defined by the SEC to include corporate officers (CEO, CFO, COO, etc.), members of the board of directors, and large shareholders (those who own more than 10% of a company).
Q Isn't this illegal?
A Insider trading usually conjures up images of corporate greed where people illegally use inside information to buy or sell stocks before the news is made public. It has always been perfectly legal for corporate insiders to buy and sell their own company's stock, as long as they do so without benefit of non-public information.
Q Why haven't I heard of this before?
A Until recently insiders had up to one month following their transaction to report it to the SEC. This extreme time delay made the information much less timely and valuable to investors. However, as part of the 2002 Sarbanes-Oxley act, insiders are now required to report their transactions within 2 business days on a Form 4. This provides investors with useful data to incorporate into their investment strategy.
Q Is all insider trading significant?
A Not all insider purchases are significant however. Among the insider purchases that you should discount are: purchases made as a part of an IPO and purchases by new insiders.
Insiders often acquire additional shares as a part of their company going public. While IPOs can often be quite profitable, insider participation does not necessarily identify the companies that will prosper.
Newly hired or promoted insiders will often make an initial purchase due to corporate bylaws requiring officers to hold a certain amount of stock.
Q What about insider sales?
A While insider purchases are indicative of positive future stock performance, insider sales do not necessarily predict a decline. Many executives have a large part of their compensation in the form of options and/or grants. So some selling by insiders can be as normal as us cashing a paycheck. Insiders may also be looking to diversify their portfolio, or to pay for other expenses (a new house, college, etc.).