Many studies have shown that investors can potentially profit from insider transactions. Insiders (corporate executives and directors) are some of the most informed participants in the market and their purchases and sales of company stock can be an excellent predictor of future stock performance.
Not all insider transactions provide valuable investment insights, however. To profit consistently from legal insider trading, it’s crucial to identify trades that have informational value.
In this guide, we are going to discuss the trades that are worth focusing on when analyzing insider transactions. By focusing on these types of transactions, you can significantly improve your chances of profiting from insider purchases and sales.
Large Trades From Top-Level Insiders
Insiders tend to have varying amounts of information on their businesses depending on the position they hold within the company. So, if your aim is to profit from insider trading, it can pay to focus predominantly on transactions from those who are likely to have a deep level of insight into their companies such as the CEO, CFO, and Chairman. These kinds of top-level insiders typically have an in-depth understanding of business trends and operating performance and as a result, they tend to be better at predicting future stock price movements.
In a 1986 study on insider trading entitled ‘Insiders’ Profits, Costs of Trading, and Market Efficiency’, Nejat Seyhun analyzed 60,000 insider purchase and sale transactions from 769 US-listed firms between 1975 and 1981. Seyhun concluded that insiders can predict abnormal future stock price changes. However, he also concluded that more knowledgeable insiders such as those high up in the organization tend to be better predictors of future stock price movements.
“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,” wrote Seyhun.
Of course, it’s also important to consider transaction size. The size of the insider’s purchase or sale can tell you a lot. The key here is to focus on the size of the transaction in relative terms by looking at the increase or decrease in the size of the insider’s holding as a result of the trade. This can provide crucial insights into how much conviction the insider has in their purchase or sale. If a CEO has just doubled the size of his holding, for example, it sends a strong signal that he is confident the stock is set to rise. By contrast, if a CEO has only increased their position by 1%, we can infer that the level of conviction is not as high.
Example: Harley-Davidson Inc
In August 2020, we highlighted the fact that Jochen Zeitz, the CEO of Harley-Davidson Inc, had just spent $2 million on company stock, increasing the size of his holding by 47%. This purchase from Zeitz was a very profitable trading signal – in the following nine months, HOG stock rose about 75% on the back of better-than-expected results.
Example: AO World PLC
In July 2020, we highlighted the fact that John Roberts, the Co-Founder, and CEO of British online retailer AO World had purchased around £1.7 million worth of company stock, paying between £1.44 and £1.69 per share for his shares. Roberts’ purchases were 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.
Large Trades in Small Companies
It’s also worth paying close attention to insider transactions in smaller companies. Smaller companies tend to be less researched than larger companies which mean that they are often less efficiently priced and can offer greater potential for large moves to the upside.
A number of studies on insider trading have found that insiders at small-cap firms tend to earn the largest profits. For example, in Nejat Seyhun’s 1986 study on insider transactions, he concluded that the most profitable insider trading tends to occur in small firms. Similarly, in a 1998 paper entitled ‘Are Insiders’ Trades Informative?’, Josef Lakonishok and Immoo Lee concluded that insider trading is a stronger indicator in small-cap stocks.
So, if your aim is to profit from legal insider trading, it can pay to look out for high-conviction insider transactions in smaller companies.
Example: Calix Inc
In May 2020, we highlighted the fact that Don Listwin, Chairman of US tech firm Calix, had just 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 12 months, Calix stock rose as high as $48 on the back of strong results.
Example: Upwork Inc
In May 2020, we highlighted the fact that Upwork board member Greg Gretsch had just spent $5.4 million on Upwork stock. At the time, Upwork had a market cap of $1.4 billion. Over the next nine months, Upwork stock rose about 375% on the back of strong revenue growth.
Finally, another pattern to focus on when analyzing insider transactions is ‘cluster buying.’ Cluster buying can be defined as a series of open-market purchases by three or more insiders in the same stock within a short period of time. So, for example, if a company’s CEO, CFO, and Chairman all buy company stock within the space of two days, that represents a cluster buy. The reason this pattern is worth focusing on is that it indicates that multiple insiders believe the company’s stock is set to rise. In other words, it shows that there is a consensus of opinion within the company that the stock is undervalued.
A number of studies on insider transaction activity have concluded that cluster buying is a powerful pattern. For example, a 2017 study by Dallin Alldredge and Brian Blank (‘Do Insiders Cluster Trades with Colleagues? Evidence from Daily Insider Trading’), which analyzed US insider trading data from 1986 to 2014, found that:
- Clustering is greater when informational advantages are larger.
- Clusters tend to take place during periods of high information asymmetry.
- Insider purchases are more proﬁtable when corporate insiders cluster their trades.
Similarly, a 2018 study by Chang-Mo Kang, Donghyun Kim, Qinghai Wang (‘Cluster Trading of Corporate Insiders’), which analyzed US insider trading data from 1986 to 2016 found that:
- Cluster buys are more informative than non-cluster insider buys.
- Cluster buying exhibits stronger return predictability than non-cluster insider purchases.
- Cluster buys have larger price impacts and lead to stronger market reaction at their disclosures than non-cluster purchases.
Example: Element Fleet Management
In May 2018, eight insiders at Canadian fleet management company Element Fleet Management purchased stock in a classic case of cluster buying. Those who purchased shares included acting CEO Daniel Jauernig (108,000 shares), soon-to-be CEO Jay Forbes (200,000 shares), and ex-Chairman William Lovatt (100,000 shares). This cluster purchase turned out to be a profitable trading signal. Over the next 12 months, Element Fleet Management stock rose nearly 75%. By contrast, the S&P/TSX Composite index rose just 1%.
Example: Crest Nicholson Holdings PLC
In late June and early July 2020, a number of top-level insiders at UK property developer Crest Nicholson Holdings purchased stock when the share price was near £2. Among those who purchased stock were the CEO, the Finance Director, the COO, and the Chairman. We wrote at the time that this cluster buying pattern was a ‘bullish signal.’ Over the next nine months, the stock rose more than 100%.
Profiting From Insider Trades
In conclusion, the key to profiting from insider transactions is to identify the most informative trades. By identifying these trades, you can improve your chances of profiting significantly.
It’s worth stressing 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 trading data can help capture alpha.