Quick definition Insider trading is using non-public information to buy or sell securities. It is illegal because it gives insiders an unfair advantage and violates the principle of fair markets. What it is An insider is someone with access to non-public information about a company. This includes executives, board members, employees, and anyone who learns information in the course of their work. If an executive learns that earnings will be much better than expected and buys shares before announcing the earnings, that is insider trading. The executive has an unfair advantage; the market price does not yet reflect the good news. Why it matters Insider trading is illegal because it undermines fair markets. If insiders can always trade profitably on non-public information, retail investors are disadvantaged. Insider trading laws protect retail investors and maintain confidence in markets. Insider trading prosecutions send a signal that securities laws are enforced. Famous insider trading cases (Martha Stewart, Raj Rajaratnam) deter many insiders from attempting illegal trades. Legal insider trading Not all insider trading is illegal. A company insider can buy or sell shares legally if they follow proper disclosure rules. An executive must file a Form 4 with the SEC when they trade, disclosing their transaction publicly. Materiality test Information is "material" if a reasonable investor would consider it important in making an investment decision. If earnings are significantly higher or lower than expected, that is material. If the company has a minor policy change, that is not material. Only material non-public information gives rise to insider trading liability. Practical example You are a software engineer at a technology company. You learn, in the course of your work, that the company's product has a critical security flaw that will require a massive recall. You know the stock price will fall when this news is public, so you sell shares before the announcement. This is insider trading. You traded on material non-public information (the security flaw) and gave yourself an unfair advantage. You would face SEC enforcement and potential criminal prosecution. Enforcement The SEC investigates insider trading by looking at trading patterns. If a trader buys shares just before good news or sells just before bad news, the pattern is suspicious. The SEC can compel disclosures and subpoena records. See also - Information Asymmetry - Materiality - Disclosure - SEC (Securities and Exchange Commission)
