Thursday, April 23, 2009

How to Use Insider Trading to Your Advantage

From LearningMarkets.

Insider trading is an often misunderstood investing tool. It can be helpful for traders, but its value is usually overstated.

This is a good topic to tackle right now as we are seeing an uptick in the number of insiders buying in late 2008 and early 2009 compared with the last year. This could indicate that insiders are becoming a little more optimistic about the market's prospects in the near term.

Insiders are technically classified as anyone with material non-public information. Usually this means employees, officers, directors or shareholders who own more than 10% of the company's stock. Insiders can trade their own stock but have certain restrictions on how, when, and how much they can sell or buy. Part of those restrictions are reporting requirements.

Because insiders must report their trades to the SEC, ordinary investors can get access to that information and can see what insiders are doing.

It makes some sense to assume that if insiders are selling stock, then they are pessimistic about the company, or if they are buying, then they must be optimistic.

On average, stocks with high insider buying do show some correlation with a rise in price; however, selling does not appear to be reliably predictive.

Peter Lynch famously said, "Insiders might sell their shares for any number of reasons, but they buy them for only one: They think the price will rise."

This statement seems reasonable and may be a good explanation for why insider buying is more predictive than selling.

There have been many studies on the topic of returns and insider trading, and one notable example suggests that a diversified portfolio of stocks with high insider buying outperformed large stock indexes by as much as 9%. This justifies some time and attention paid to the subject.

In the following video, I will cover the definition of insider trading and show an example of the impact that this activity can have on a stock's price.

Two Ways to Make Insider Trading Work For Your Portfolio

As I mentioned above, insider trading information can be useful, but it can also be overstated or over-relied on. Used prudently, it may alert you to increased risk in stocks you already own and could even be used to find stocks and options to add to a watch list as a potential investment.

Insider trading information be used in two ways:

1. Monitoring insider sentiment in stocks you own.

If insiders are suddenly buying a stock you own, it may indicate that there is some very positive sentiment inside the company. That may change your risk control behavior by encouraging you to leave the position uncovered or to add to the position within your portfolio. Before making a decision based on insider trading, you should consider who is buying and how much they are acquiring.

For example, if an officer like the CFO is buying, that may be much more relevant than a director. Similarly, if an officer or director is buying very large quantities of stock, that may be something that deserves attention.

Yahoo (YHOO) experienced significant insider buying by Carl Icahn in his effort to increase his strategic influence on the company's management in late November 2008, and the stock rallied.

2. Using insider buying to find stocks for investment.

The filtering process to find stocks that you do not already own with high insider buying could be very daunting if it were not automated. Fortunately, there are both free and pay services that do an excellent job at filtering and reporting the data for you. In the video below I will cover three services that I recommend for this kind of research.

Insider buying should not be the only qualification you use to decide on a company to buy. It is merely an alert that something interesting might be happening. Doing fundamental analysis, and making sure a potential investment conforms to your portfolio diversification strategy is still critical.

Good investing, Kingsley.

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