Peter Lynch, the legendary Fidelity Investments Manager, once said: “Insiders may sell their shares for a variety of reasons but they only buy them because they think that the price will increase.”

Lynch believed that it was important to understand a company’s product and its practices before investing. 1 As a group, does anyone know a business’s product, its management and prospects better than the company’s leaders? Investors can capitalize on insider information by tracking public databases that track the buying of insiders.

Following the purchasing activities of insiders of a business is an important part of due diligence before investing in it. How to do it.

The Key Takeaways

• Insider purchases, where company executives purchase their own stock, can indicate confidence in a company’s future and its potential for investment.
• Insider purchases that are legitimate and publicized provide valuable insight into the health and future of a company.
• Insider buying is not only about the act but also about the amount, timing, and track record of the buyer.
• Edgar, the SEC database, allows public access to all filings relating to insider trading and buying of shares.
• Many financial platforms provide easier-to-use databases to facilitate insider purchasing.

Insiders: Who are they, and why do they buy or sell?

The U.S. Securities and Exchange Commission defines insiders as “management, officers, or any beneficial owner with more than 10% of a company’s securities.” 2

Insiders are required to follow certain rules. This includes filing SEC forms when they buy or sell shares. To prevent insider trading or gaining illegally from nonpublic material information, the law prohibits insiders from disposing of shares within 6 months of purchase.

It effectively prevents insiders from making quick swing trades using their knowledge. 3

Tip

It pays to keep an eye out for insider activity. Insiders who believe their stock will rise or fall are probably right. It’s possible that they don’t even know why they are trading.

What does it mean when insiders buy or sell?

Insider buying is generally a sign of management confidence and a bullish signal. Insiders believe that their stock is likely to rise. Insider sales are considered to be bearish. Those who know the truth may be selling their stocks in anticipation of a price drop.

The Effect of Post-Earnings Announcement Drift

Numerous studies have looked at the relationship between “post-earnings-announcement drift” (PEAD) and insider trading. Stock prices can continue to move in the direction of earnings surprises even weeks or months after an announcement. Researchers have found that:

• Insider trading prior to earnings announcements tends to reduce the PEAD effect. This means that the market is likely to take insider moves to signal an upcoming announcement.
• This is particularly true for “contradictory trades” (e.g. insiders selling or buying before good news).
• It is more pronounced in niche markets with sophisticated investors.

Insider trading could improve market efficiency if it helps investors understand the long-term implications of earnings announcements. 4

Lan, Qiujun. Yuxuan Xie. Xianhua mi. Chunyu zhang. “Post-Earnings Announcement Drift”: A Simple Earnings Surprise Measure, The Medium Effect of Investor Attention and Investing Strategies. International Review of Financial Analysis 2024, vol. 95, Part B.

Signalling and Stock Price Management

Some studies have looked at why insiders trade even though the gains are often small compared to the risks. The following are some of the key findings:

• Most insider purchases don’t yield significant profits above market averages.
• About a quarter (25%) of all insider transactions result in abnormal returns.
• This suggests that the main motivation for insider buying may not be immediate profits. 4

Researchers have shown how insider trading is often used as a means of signalling.

• Insiders can buy shares to show their confidence in a company, especially during difficult times.
• These purchases may indicate positive information that is not disclosed without breaking disclosure rules.
• You can use them to counteract negative sentiments or excessive short-selling, particularly during times of bad earnings news.
• These methods are used to replace traditional methods of disclosure, such as earnings forecasts and conference calls.
• Insiders can sometimes try to build short squeezes on behalf of those who are shorting a company while they receive positive earnings surprises.

Implications to Investors

The findings of this study have implications for investors in terms of how they interpret insider trading.

• Insider purchases before earnings announcements could signal news that is more significant or persistent than what the market anticipates.
• Insiders may not be confident if they don’t see profits. This could simply be a strategy to demonstrate a company’s strength.
• Investors need to consider the context of insider trading, which includes the company’s recent performance and market sentiment.
• Insider transactions are still useful, but they should be part of a complex communication and signalling strategy. They shouldn’t just be a buy/sell indicator. 6

Insider Buying In The U.S.

The SEC requires all public companies to report insider trading within two days, except for the smallest microcaps. They must also file SEC Form-3 when the company is first acquired, SEC Form-4 for every change, and SEC Form-5 if there are any changes not previously reported or eligible for deferral.

The SEC’s S Electronic Data Gathering, Analysis, and Retrieval database (EDGAR), a collection of legal documents specific to each company listed publicly on a U.S. exchange, contains Form-4 filings. You’re in luck if combing through the EDGAR database is too time-consuming. Many financial news sites track and publish information about insider trading.

What is Form 4?

Form 4 is an SEC form entitled “Statement on Changes in Beneficial ownership.” The SEC requires it to be filed when there are material changes in an organization’s insider holdings. It must be submitted within two days of the transaction.

These forms are part of the EDGAR database. They are publicly searchable and accessible, so anyone can see them as they’re submitted to learn about changes in the insider ownership.

Search EDGAR through the SEC website. You can search by company name, ticker symbol or Central Key Index. The SEC uses this value to identify companies and individuals who have filed disclosures.

How to read Form 4

Once you get used to Form 4, it’s a multi-page document.

The first page of the report contains the basic information regarding the transaction that is being reported.

• Name of the person reporting
• The ticker and issuer name of the security is in question
• Date of first reporting transaction
• Relationship of insiders to issuers, such as whether or not they are a director, an officer, or a 10% shareholder

This page tells you who traded, what the security involved, and how the trader was related to the company.

The second and third pages of Form 4 are used to list all reported transactions.

• Security is paramount
• Date of Transaction
• Date of the transaction
• Transaction code
• The number of securities traded and their prices
• The reporter held the remaining securities after the transaction.

Page 2 contains securities, and page 3 includes derivatives.

This page shows the number of shares bought or sold. It also shows the new interest that the insider has in the company after the trade. And it tells you when the trades took place. The transaction code identifies the type of trade, including whether it was an acquisition or sale, grant of shares, conversion of options, etc. The instructions for Form 4 explain all of the possible transaction codes and what they represent.

Explain like I’m five.

Insiders have privileged access to the inner workings of a business, including its directors and executives. Insiders must file public disclosures when they make large trades to prevent them from unfairly profiting from their knowledge. The SEC, as well as some investment websites, provide these disclosures.

These disclosures reveal to regular investors what the insiders believe about their company’s prospects. Insiders who make large purchases could indicate that management is confident in their direction. Conversely, insiders who sell-off could signal trouble. Size, timing, and an insider’s history all contribute to determining whether or not an insider transaction is positive.

Is Insider Trading Illegal?

Insider trading is illegal. This involves trading securities or stocks of a company based on information that’s not publicly known. Insiders are not prohibited from trading, but they must follow certain rules. Insiders are required to follow certain rules and report their trades using Form 4.

How can I track insider buying and selling?

You can use EDGAR to keep track of insider trading for a particular company. Online services track insider trading and present this information to investors. 2

What are the penalties for illegal insider trading?

Insider trading is punishable by stiff fines. The penalties for insider trading based on material nonpublic information are severe.

The Bottom Line

Insider buying refers to the practice whereby corporate insiders, such as directors, executives, or major shareholders, purchase shares of the company’s stock in the open market. Investors and analysts are closely monitoring this activity, which could provide insight into the company’s prospects. Insiders will buy shares if they think the stock is undervalued or if they are confident in the company’s future performance.

These transactions are public and must be reported by the SEC. This allows outside investors to track, analyze, and review this information. Insider purchases can be positive signals, but it is important to put them in the context of other transactions. The amount of trading relative to an insider’s current holdings, the timing of the transaction, and the insider’s historical trading patterns all play a part in interpreting their significance.

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