Insider trading is illegal when it’s based on material nonpublic information. Yet it’s quite widespread. Sometimes insiders intentionally leak material information. Perhaps they tell a close friend who can then trade on that information and share the profits. Those people profit from the inside information illegally. But even though it’s illegal, it’s tough to catch and prosecute. As a result insider trading is rampant in our markets and the idea of a “level” playing field is surreal (except for believers of the Efficient Market Hypothesis).
But it is possible for outsiders to legally profit from illegal insider trading. Here are three ways you can legally profit from material nonpublic information:
1. If you overhear material nonpublic information in public, you can trade on it and your profits from your trade would be legal. For instance, suppose you’re a Pakistani cab driver in New York City and during one of your rides you overhear your passenger say that Company A will acquire Company B the next day. You can go ahead and buy millions of dollars worth of stock options and get rich instantly and it will be legal. This is because you have no fiduciary duty against anybody when you hear the information. Just keep your ears open.
2. Insider Monkey, your source for free insider trading data, knows that it’s very unlikely for someone to come across material nonpublic information accidentally. There is a better way. Academic studies have shown that stocks intensively bought by insiders beat the market by more than 7% per year. The reason is pretty clear. Insiders have better (and sometimes material nonpublic) information and they take advantage of their inside information. Of course, not every insider purchase depends on inside information. But if you monkey insider transactions that are more likely based on material nonpublic information, you would profit on the average. One way to identify profitable investment strategies is to analyze published insider trading research. Insider Monkey developed proprietary quantitative methodologies that increase the likelihood of detecting illegal insider trading. Instead of publishing our results in a respectable journal we decided to profit legally by imitating these (probabilistically) illegal insider transactions. We’ve shared our methodology with large qualified hedge funds. Law enforcement agencies could also use this information.
3. Hedge funds and mutual funds sometimes identify material nonpublic information. Either they work hard and uncover it, or they simply pay for it. The way this system works will be more clear when Preet Bharara, the United States Attorney for the Southern District of New York, charges dozens of hedge fund “analysts” and traders with illegal insider trading. It doesn’t matter how they got a hold of material nonpublic information for you to profit legally from it. All you need to do is determine which funds have respectable alpha, and then imitate the holdings of those hedge funds. If they truly have alpha, then their abnormal returns will also be persistent. You can beat index funds by imitating those hedge funds.