Insiders trading effect
Insiders are market participants that have access to non-public information relevant to a security price. Trading on non-disclosed information is forbidden in most markets. However, company executives that receive compensation in shares are legally permitted to buy and sell shares of the firm that employs them. As these trades are properly registered with the regulator, insiders lose that ability to front-run the market and take advantage of inside knowledge of their company. Some believe, however, that a record of insiders’ trades carries information that is not fully absorbed by the market. In such a case, it would be possible to earn excess return utilising the information contained in insiders’ trades – “insiders effect trading strategy“. The central argument is that insiders are better informed about the fundamental value of their firms. Thus their buying and selling patterns reflect whether the firms are (or perceived to be) underpriced or overpriced. This idea has sparked an interest in both academic and practitioners’ research.
The legendary Fidelity Investments manager Peter Lynch once said, “Insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise.” Studies based on US data show that insiders are indeed better informed and earn abnormal returns (Lorie and Niederhoffer (1968), Jaffe(1976), Finnerty(1976) Seyhun(1986), Rozeff and Zaman(1988), Lin and Howe(1990) and Jeng, Metrick and Zeckhauser (1999)). Some of the later evidence is presented by Lakonishok and Lee (2001) who observes long data of over a million trades in the US stocks which most had been traded by an insider. They affirm previous findings of excess returns of insiders with an average 10% difference between portfolios of insider-sold stocks and insider-bought stocks. In addition, insiders tend to make more from buying small-cap growth stocks which is due to the lesser market efficiency of this segment; however, insider profits are still 4.8 % after adjusting for measures such as Book to Market factor and size factor. Although investors do not seem to follow insiders very closely, the trading activity rises only 0.5% after insider trading is reported. Lastly, implementing investment strategies is not straightforward as only insider purchases appear to be useful, while sales are not associated with low returns, and small stocks purchases that are associated with high returns are costly to trade.
As insider action is mostly only effective as a buy recommendation, insider inaction, on the other hand, suggests a relation between regulatory imposed insider silence and extreme or often negative future returns. First, insiders of merger targets refrain from buying in the months before the merger announcement, and insiders of bankruptcy firms refrain from selling before the bankruptcy filing. Second, among firms that are likely to have bad news, insider silence predicts significant negative future returns, which are even lower than when insiders net sell. Further, the negative information in insider silence is gradually incorporated into stock prices, and a significant portion of it is released around quarterly earnings announcements. For literature conserving insiders effect see Bettis, Coles, and Lemmon (2000), Ke, Huddart, and Petroni (2003), Cheng and Lo (2006, p. 821), Piotroski and Roulstone (2008), Rogers (2008, p. 1269), Lee, Lemmon, Li, and Sequeira (2012), among others.
Further attempts to find profitable trading strategies try to combine the insiders’ effect with other market phenomena. For example, combining momentum in stocks or information on short selling has been shown to amend the profits from following insider trading leads. The reason is likely due to clearing the noise from insider trading buy or sell signal. As a lot of insider transactions are not by themselves always caused by profit-seeking, considering it jointly with other indicators has been found to result in a more robust forecast.