The insider trading anomaly was first formally identified by James Lorie, a stock market researcher at the University of Chicago, and Victor Niederhoffer, a professor and trader, in a 1968 paper entitled ‘Predictive and Statistical Properties of Insider Trading’ (The Journal of Law and Economics, 11, 1968, 35-53). Lorie and Niederhoffer concluded that proper and prompt analysis of data on insider trading can be profitable, which went against the findings of previous studies on the topic.
Since then, a significant number of studies have explored the link between insider transaction activity and stock returns and drawn similar conclusions. Despite the fact that much has changed in the investment markets over the years, research indicates that the predictive properties of insider buying and selling remain as relevant today as they were half a century ago. Here, we will provide an overview of the academic research on insider transaction activity and highlight some of the key findings.
Nejat Sehun: An Expert On Insider Transactions
Some of the most well-known studies on insider transaction activity were conducted in the 1980s and early 1990s by Nejat Seyhun. Seyhun studied insider trading extensively and authored a book on the topic entitled ‘Investment Intelligence from Insider Trading.’
In a 1986 study entitled ‘Insiders’ Profits, Costs of Trading, and Market Efficiency’ (Journal of Financial Economics, 16.2, 1986, 189-212) Seyhun investigated whether insiders could earn abnormal profits by buying and selling shares in their own companies. In his research, he analyzed 60,000 insider purchase and sale transactions from 769 New York Stock Exchange (NYSE) and American Stock Exchange (AMEX) listed firms for which at least one insider transaction was recorded between 1975 and 1981.
Seyhun concluded that insiders can predict abnormal future stock price changes. His research showed that insiders purchased stock prior to abnormal rises in stock prices and sold stock prior to abnormal declines in stock prices.
However, he also concluded that different insiders possess differences in quality of information.
“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
Additionally, Seyhun noted that most profitable insider trading occurs in small firms.
In a 1988 paper, Seyhun focused on the relationship between market movements and aggregate insider trading in a paper entitled ‘The Information Content of Aggregate Insider Trading’ (The Journal of Business, 61.1, 1988, 1-24). His goal here was to determine whether publicly-available information about aggregate insider trading activity can help predict future stock-market returns and provide market analysts with market timing ability. In this study, he analyzed 60,000 open-market purchases and sales by insiders from January 1975 to October 1981.
Seyhun found that the net aggregate insider activity in a given month is significantly positively correlated with the return to the market portfolio during the subsequent two months. His research showed that, in the aggregate, insiders increased their stock purchases prior to increases in the stock market and decreased their stock purchases following increases in the market. This is in line with our own research.
Seyhun followed up his work on insider transactions with another study in 1992 entitled ‘Why Does Aggregate Insider Trading Predict Future Stock Returns?’ (The Quarterly Journal of Economics, 107.4, 1992, 1303-1331). This study examined whether the ability of aggregate insider trading to predict future stock returns can be attributed to changes in business conditions or movements away from fundamentals. Seyhun concluded that both explanations contribute to the predictive ability of aggregate insider trading.
Seyhun also found that for the period from 1975 to 1989, the aggregate net number of open market purchases and sales by corporate insiders in their own firms predicted up to 60% of the variation in one-year-ahead aggregate stock returns.
Insider Transactions: Research In The 1990s and 2000s
In the late 1990s and early 2000s, a number of informative papers on insider transaction activity were published.
One paper that is worth highlighting is ‘Are Insiders’ Trades Informative?’ by Josef Lakonishok and Immoo Lee (National Bureau of Economic Research, Working Paper 6656, 1998). This particular study examined insider trading activities of all companies listed on the NYSE, AMEX, and Nasdaq exchanges between 1975 and 1995.
Lakonishok and Lee found that when insiders were optimistic, markets on average performed well and when they were pessimistic, markets performed poorly. They concluded that insiders are contrarian investors and can time the market better than a simple contrarian strategy.
At the level of individual firms, Lakonishok and Lee concluded that insider activity can predict stock returns. They found that stocks with extensive insider purchases outperformed those with extensive sales. However, they stated that insider purchases are more informative than insider sales.
Lakonishok and Lee also found that insider trading is a stronger indicator in small-cap stocks. This is a segment of the market that is often perceived to be less efficient.
“We observe that the largest spread in returns between stocks that insiders buy and sell is in small-growth stocks. Insiders in general are heavy sellers of such stocks, and indeed, those stocks are associated with relatively low returns. However, when they buy such stocks, insiders know what they are doing.” – Lakonishok and Lee
Another key paper during this period was ‘Estimating the Returns to Insider Trading: A Performance-Evaluation Perspective’ by Leslie A. Jeng, Andrew Metrick, and Richard Zeckhauser (The Review of Economics and Statistics, 85, 2003, 453-471). This study aimed to calculate insiders’ actual returns for their purchases and sales when they trade their company’s stock. It studied insider transactions from 1975-1996.
Jeng, Metrick, and Zeckhauser found that insiders who bought stock earned abnormal returns of between 52 and 68 basis points per month for the first six months. However, they found that about one quarter of these abnormal returns accrued within the first five days after the initial transaction, and one-half accrued within the first month.
Jeng, Metrick, and Zeckhauser concluded that insider buyers have a good feel for near-term developments within their firm. They also concluded that higher-volume purchases have larger abnormal returns than low-volume purchases.
Recent Academic Research On Insider Activity
In the last decade, a number of studies have explored the link between insider transaction activity and stock returns further.
One paper of note is ‘Identifying Profitable Insider Transactions’ by Kaspar Dardas of the European Business School, which was published in 2011. This study examined long-term excess returns subsequent to directors’ dealings announcements between January 2002 and December 2009 from 17 Western European countries.
Dardas’ research showed that long-term positive (negative) excess returns existed after insider purchase (sale) transactions. It also showed that multiple trades by different insiders in the same direction led to higher excess returns.
In terms of returns, his research showed that ‘high conviction’ insider purchases generated an average 12-month excess return of 20.94%, while medium conviction purchases generated 1.32% and low conviction purchases generated -3.40%.
Dardas concluded that substantial long-term excess returns exist in European stocks after insider transactions. However, he noted that not all insider transactions can be taken as highly informative or ‘high conviction.’
“To obtain the best results in mimicking insider trading strategies it is necessary to filter high conviction transactions.” – Kaspar Dardas
More recently, a number of studies have taken a closer look at ‘cluster buying.’ Cluster buying is where multiple insiders are buying stock within a short period of time.
A 2017 study by Dallin Alldredge and Brian Blank entitled ‘Do Insiders Cluster Trades with Colleagues? Evidence from Daily Insider Trading’ (Journal of Financial Research, 42.2, 2019, 331-360), is worth highlighting here. This study, which examined US open market sale and purchase transactions data from January 1986 to December 2014, found that insider purchases were more proﬁtable when corporate insiders clustered their trades.
The researchers here found that clusters generally took place during periods of high information asymmetry (information asymmetry was measured using subsequent earnings surprises). Their data showed that insider purchases that occured within two days of a peer insider purchase obtained monthly abnormal returns of 2.1% over the next month – 0.9% higher than the abnormal returns following solitary insider purchases.
Another study in 2018 by Chang-Mo Kang, Donghyun Kim, Qinghai Wang entitled ‘Cluster Trading of Corporate Insiders’ also focused on cluster buying. This study, which analyzed US corporate insider trading data from 1986 to 2016 found that cluster purchases had larger price impacts and led to stronger market reaction at their disclosures than non-cluster purchases.
The research showed that over holding periods of 21 trading days, the abnormal returns earned by cluster purchases were almost twice as high as those of non-cluster purchases (3.8% vs. 2%). The return gap was even wider over longer horizons, reaching 2.5% over a 90-day horizon.
Kang, Kim, and Wang concluded that cluster buys of top executives, not just with other top executives but with other executives and directors, are more informative than individual insider purchases.
How To Profit From Insider Transactions
In conclusion, the evidence suggests that insider transaction activity does have predictive power. A large number of studies – analyzing data over several decades – have shown that insiders can earn abnormal returns.
However, the research indicates that not all insider trades are created equal. The takeaway from these studies is that to profit from insider transaction activity, investors should focus on ‘high-conviction’ trades. Specifically, investors should focus on:
Insider purchases more than insider sales
Trades involving top-level insiders
Trades that are large in size
Trades in smaller companies
Trades that are clustered together
By focusing on high-conviction insider transactions, outsiders can potentially use insider transaction data to capture alpha and generate higher returns.
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