What is Insider Trading?
Insider trading refers to the trading of securities by corporate insiders such as managers or executives. Insider trading can be legal or illegal depending on if the information used to base the trade is public.
How Does Insider Trading Work? (Example)
Individuals who engage in illegal insider trading attempt to benefit from trades based on information about a company not yet made public.
For example, an executive of Company XYZ who purchases shares of the company based on a pending merger announcement is engaging in illegal insider trading.
However, once Company XYZ has announced the merger publicly, insiders such as Company XYZ executives, managers and employees may legally trade the shares based on the information.
To comply with insider trading laws, insider transactions must be reported to the Securities and Exchange Commission (SEC) via Form 4.
Why Do Investors Follow Insider Trading?
Some investors follow legal insider trading because they believe insiders have a better insight to the financial health of a company. For example, a CEO buying shares of his company conveys confidence in the future of the business.
Meanwhile, illegal insider trading can lead to fine and even imprisonment for the guilty party.
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