Insider trading is illegal – there are countless examples of people going to jail for taking advantage of privileged information.
However, there is a form of ‘insider trading’ that is perfectly legal. And as investors, we can make use of these transactions to clue us in when evaluating the company’s prospects and assessing current stock prices.
In this post, we’ll explore the legal framework of these transactions and why they are worth paying attention to. We’ll also look at how investors can use these transactions as a tool to gain insight into the future of a company.
Insider Trading VS Director’s Transactions
To begin, let’s define “insider trading” and “directors’ transactions.”
Insider trading is a practice that refers to the buying or selling of a security by an individual who has access to information that is not available to the public. Due to their privileged position, they are able to gain an unfair advantage over other investors in the market.
Directors’ transactions, however, refer to the buying or selling of securities by a company’s directors, officers or significant shareholders. This type of activity is entirely legal and can be used as a useful indicator of the company’s future.
Insider Behaviour Can Give Us A Clue Of What’s Going On
Insider trading is illegal, but that doesn’t mean investors should ignore directors’ transactions. In fact, these transactions can provide valuable insight into the company’s prospects.
Directors are privy to inside information that can give us an edge in the stock market and help us make better investment decisions. By analyzing their trades we can gain insight into their expectations for the company’s future performance, which has implications for our investments.
In his book, One Up on Wall Street, Peter Lynch, the famous American investor, summed it up by saying,
‘There’s no better tip-off to the probable success of a stock than that people in the company are putting their own money into it … When insiders are buying like crazy, you can be certain that, at a minimum, the company will not go bankrupt in the next six months. When insiders are buying, I’d bet there aren’t three companies in history that have gone bankrupt near term.’
In other words,
- If a director buys stock, it could be an indication that they believe the company has good prospects and are confident in its future performance.
- On the other hand, if a director is selling stock, it may suggest that they have concerns about the company’s future or that they are facing financial difficulties
Watch Insider Behaviour Closely When This Happens
A director’s judgement is especially telling when a stock falls.
This is because rather than predicting the success of a stock way into the future, something that depends on a director’s judgement, it tells us that there is nothing being hidden from us, the investors.
If the buying is by a director that has earned our respect (even better if it is more than one), then the clues provided are even more meaningful.
Is A Director Selling Always A Bad Omen?
Not necessarily.
There can be a number of reasons a director may sell. Retirement is one reason, they may simply need some extra money for purchasing a new car or, they are looking to diversify.
What’s important is to pay attention to the context of when it is happening and the size and frequency of the transaction.
Here’s what Lynch said about director selling:
“If a stock had gone from $3 to $12 and nine officers were selling, I’d take notice, particularly if they were selling a majority of their shares. But in normal situations, insider selling is not an automatic sign of trouble within a company.“
The important thing to keep in mind is that while director sales are not always bad, they are never good. If we look closely at a sale, it can provide hints that can be very useful.
The Bottom Line
It’s important to note that directors’ transactions should not be taken as an absolute indicator of potential success or failure. Decisions made by investors looking at director transactions must always be accompanied by thorough research into the financials of a company, the state of the market, as well as the current economic conditions.
However, if used properly and intelligently, director transactions can add an extra layer of information that could prove extremely useful.
Terry
