Insider Trading Education Center

Beat the Market Using Insider Information

Without ever having met you, I can confidently say that hedge fund managers and corporate insiders know more than you do. Why is this important? It’s important because hedge fund managers and insiders are the crème of the investment underworld, and just by understanding a few simple concepts, you can be their alpha parasite.

Insider trading is not illegal. The truth is that in practice, insider trading is more legal than illegal. It’s only when the insider is trading based on market-moving (a la material) and non-public information that it’s illegal. But here’s the thing — how can you possibly prove what motivated an insider to trade? If you’re Rajaratnam and Batman Bharara arranges wire taps, then yes, well there’s not much room to argue. Same goes if Sam Shady gets his sister to put in options that are perfectly timed with an imminent M&A announcement. That’s just stupid. Most insiders aren’t stupid; they know they’re being watched. It’s inevitable that among the tens of thousands of insiders, a few will find the loopholes in the SEC regulations (as there are many) and profit from them and still escape the wrath of the SEC. Essentially, insiders can possess material information, trade on it, and then say they didn’t. It’s a tough thing to prosecute. Again, unless there are wiretaps or material witnesses.

By the time you find out about the insider’s trade, you still have time to mimic their moves and get a payoff. Several academic studies show that there’s plenty of time after a trade has been made public to purchase a stock being targeted by an insider and come out ahead of the overall market. One of the most infamous studies done on insider trading shows that the purchases of certain insiders beat the overall market by more than 7 percentage points over the following 12 months.

It’s true that effective investing relies on in depth analysis, but here you don’t have to be the one slaving away at the calculations. Hedge fund managers have a ton of money to invest and they do ample research. Some of them know what they’re doing, and the best way to find out which ones do is by calculating their alpha (or look up their alpha on Insider Monkey). You’ll find out quickly who has stock picking skill.

There are tens of thousands of insiders, but there is a proven method to spot out the stocks that are bound to move up. Consensus criteria reigns king. Insiders may or may not do the research, but by definition they have access to information that people outside the company do not. When there is consensus among insiders, who are acting independently, returns to insider trading are much higher.

According to a few Harvard and Yale professors ( more on them here ), insider sales are not profitable (people sell for many reasons, not just to get out of an investment) but insider purchases are extremely so (people put their money where they think it has the best chance of growing). Their study shows insider purchases beat market returns by 11.2% per year in raw returns.

Hedge fund managers are highly secretive and although the SEC makes their filings public, the data is unprocessed. For a reader who doesn’t have an advanced degree in quantitative finance, it may appear to be pure gibberish. Insider Monkey provides hedge fund holdings for free, and the stocks are cross-referenced with the insiders who are active in it. It’s the only place online you can get the data that way. Plus, it’s in real time and best of all, it’s free.

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