What can we learn from insider trading?

The phrase “insider trading” means different things to different people. If you haven’t spent much time investing in stocks and other securities, you probably think of rich people like Martha Stewart going to jail for cheating the system. Once you’ve started investing, though, your ears may perk up as you hear the words because they mean someone’s giving you a good sign of future changes.

The truth is that insider trading is both these things. There are legal and illegal versions. Moreover, you can legally buy and sell stocks in the company where you work—so long as you follow the guidelines. And it’s possible to break the law for insider trading even if you’re not a Goldman Sachs investment banker or you’ve never met anyone at the company.

When insider trading is illegal

According to the definition given by the U.S. Securities and Exchange Commission (SEC), there are two key standards for illegal insider trading:

• Breach of trust: Illegal insider trading happens “in breach of a fiduciary duty or other relationship of trust and confidence.”
• Insider information: Illegal insider trading makes use of “material, nonpublic information” that gives traders an advantage in the market.

Notably, you don’t have to be a company executive to commit illegal insider trading. You don’t even need to be part of the company. The SEC believes that dealing in privileged information undermines the whole concept of the free market, so it rarely excuses anyone based on a “breach of trust” argument. Instead, if you were to make trades based on privileged information, you could be violating the trust other investors hold in the market itself.

The steps insiders need to take to trade legally

The government doesn’t necessarily consider you an insider just because you work for a company. You need to tread carefully if you have insider information, but only a select group of people qualify for full company “insider” status:

• Directors and senior officers
• Individuals who own more than 10% of a company’s voting shares

These people can still buy and sell company stock, but they’re not supposed to sell stock within six months of buying it. The SEC also forces them to report their trades. Anytime these insiders conduct trades, they need to fill out Form 3, 4 or 5 and send it to the SEC before the appointed deadline.

Knowing the difference can make a difference

Knowing the difference between legal and illegal insider trading can mean the difference between making a profit in the stock market and finding yourself charged with a federal offense. Large insider stock purchases often signal strong faith in the company’s future. But you need to be careful about the information on which you base your trades. Trades based on privileged information can get you in big trouble.