A large number of studies – analyzing data over several decades – have shown that investors can potentially profit from legal insider trading. Insiders are some of the most informed participants in the market and their trading activity can be an excellent predictor of future stock performance.
Profiting from insider buying and selling is not as easy as it sounds, however. There are many different types of insider trades and not all are created equal. To profit consistently from insider transactions, it’s crucial to separate the informative trades from the uninformative ones.
In this guide, we are going to discuss some simple strategies that can help identify the most informative insider trades. By employing these strategies, investors can dramatically improve their chances of profiting from insider trading.
Focus On Trades From Top-Level Insiders
Corporate insiders tend to have varying amounts of information on their companies depending on the position they hold within the organization. So, if your goal is to profit from insider trading, it makes sense to focus predominantly on transactions from those who are likely to have a high level of knowledge on the company such as the Chief Executive Officer (CEO), the Chief Financial Officer (CFO), the Chief Operating Officer (COO), and the Chairman. These kinds of insiders typically have the most comprehensive insight into their companies and are often highly-skilled businesspeople as well.
“Insiders who are expected to be more knowledgeable with the overall affairs of the firm, such as chairmen of the boards of directors or officer-directors, are more successful predictors of future abnormal stock price changes than officers or shareholders alone” – Nejat Seyhun, ‘Insiders’ Profits, Costs of Trading, and Market Efficiency’
Trades from other insiders such as board members shouldn’t be ignored completely, of course. Quite often, these insiders have access to valuable information as well. However, research has found that those who are more knowledgeable with the overall affairs of the firm, such as C-suite executives, tend to be more successful predictors of future abnormal stock price changes.
Example: AO World PLC
In July 2020, John Roberts, the Co-Founder and CEO of British online retailer AO World purchased around £1.7 million worth of company stock, paying between £1.44 and £1.69 per share for his securities. This purchase was timed superbly – over the next four months, AO World’s share price rose as high as £4.20 on the back of several strong trading updates from the company. Clearly, as CEO, Roberts was able to see key business trends before the rest of the market and he was able to use his information advantage to profit.
Tip: Corporate insiders sometimes set up plans to sell a predetermined number of shares at a predetermined time. In the US, this is done through Rule 10b5-1 trading plans. Generally speaking, these automated transactions are much less informative than regular transactions.
Focus On Large Trades
Transaction size is important when it comes to profiting from legal insider trading. The size of the trade can provide crucial insights into how much conviction the insider has in their purchase or sale.
Size must be placed in context, however. A $100,000 purchase can be significant for some insiders. However, it can be relatively insignificant for an insider who already owns $20 million worth of company stock.
The best way to analyze the size of an insider trade is to examine it both in nominal and relative terms. First, compare the size of the transaction to past transactions from the insider, and/or transactions from other insiders at the company.
Then, look at the impact of the trade on the size of the insider’s holding. Has it increased or decreased the size of their holding significantly? If the answer is yes, that trade should be viewed as a high-conviction trade.
Example: Harley-Davidson Inc
In August 2020, Jochen Zeitz, the CEO of Harley-Davidson Inc spent $2.0 million on company stock, increasing the size of his holding by 47%. This trade was timed well – over the next four months, HOG stock rose about 35% on the back of better-than-expected results.
Look For Cluster Buying
One of the strongest insider transaction signals is what’s known as ‘cluster buying.’ This is where multiple insiders are buying stock within a short period of time. So, for example, if a company’s CEO, CFO, and Chairman have all purchased stock within a week, that’s a cluster buying pattern.
This pattern is a powerful signal because it shows that there is a consensus of insider opinion. If only one insider has purchased stock, investors can’t be sure that the outlook for the stock is favorable. That insider may simply be an optimist. However, if five insiders have just purchased stock, it’s a sign that insiders are in agreement that the outlook for the stock is favorable. That’s a powerful insight. Research on cluster buying has found that it tends to occur during periods of high information asymmetry.
Example: MGM Resorts International
In late March and early April of 2020, multiple insiders at MGM Resorts International purchased stock at prices of between $10 and $15 per share. In the next two months, MGM stock rose to $24, delivering a gain of between 140% and 60% for these insiders.
Pay Attention To Insider Trading At Smaller Companies
A number of studies on insider transaction activity have found that the most profitable transactions occur in smaller companies. In the small-cap space, stocks are less researched. This means there’s more potential for earnings surprises and large share price gains. So, if your goal is to generate big gains from insider trading, it can pay to look out for insider transactions in smaller companies.
Example: Calix Inc
In May 2020, Calix Chairman Don Listwin bought 30,000 shares in his company at a price of $12.11 per share. At the time, Calix had a market capitalization of less than $700 million. Over the next six months, Calix stock doubled in price on the back of very strong results.
Focus On Insider Buys More Than Insider Sales
Finally, research shows that insider purchases tend to provide more reliable trading signals than insider sales.
Insider purchases are generally quite easy to interpret. If an insider is willing to spend their own money on stock, it suggests that they expect the stock rise. No insider spends their own money on company stock if they believe its price is set to fall.
Insider sales are a little bit harder to interpret, however. This is due to the fact that there are plenty of legitimate reasons that insiders sell stock that have nothing to do with their companies’ future prospects or stock price. Sometimes, insiders sell stock to pay tax liabilities. On other occasions, they sell stock to buy property or diversify their portfolios.
"Insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise” – Peter Lynch
Given that insider purchases are easier to interpret than insider sales, it makes sense to focus more on insider buying than insider selling when analyzing insider transaction activity.
Profiting From Insider TradesIn conclusion, the key to profiting from legal insider trading is to identify the most informative transactions. By identifying these trades, investors can improve their chances of capturing alpha significantly.
It’s worth pointing out that the best way to use insider transaction data is to combine it with other forms of investment analysis. When used in conjunction with other data, insider transactions can really provide an edge.