Insider trading is essentially in a nutshell the trading of stocks or securities of a company/corporation by a person or persons with knowledge or information about the company that is not public knowledge.
In most cases insider trading is legal. However, the practice becomes illegal when “material” non-public information is obtained and used to provide an edge or advantage. This is particularly targeted in the USA and Germany where the trader is of substantial position, and owns a significant portion of the company’s equity securities.
One of the most profitable practices for inside traders, and one that is legal, is to profit from open market repurchases.
Why it is not allowed?
Because:-
It hampers Integrity of Capital Markets, the underlying principle is that information asymmetry should be minimized and any rational investor should have fair play in markets.
Government has strict laws against it because Insider trading leads to market manipulation, the ultimate losers are small investors which act on public information.
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The key term to know here is MNPI, or Material NonPublic Information. It must meet both tests.
Both terms have a lot of wiggle room. What if you hear something disclosed at a conference, with only 30 people in the room? The SEC’s Regulation FD tries to address this by forcing publicly traded companies to disclose material information as widely as possible at the same time.
Information must also be material, which can be subject if some debate. Let’s say a friend is an employee at a branch of a company whose stock you own. He says that they just lost a major contract. If that contract is only 0.5% of company revenues, and isn’t very profitable anyway, then it’s not material to results. If it’s 10% of revenues, then that’s probably material.
Analysts have one exception to this rule (which has come under pressure lately) – the “mosaic theory.” If a hard working analyst conducts a survey, where each data point in the survey is immaterial, but the sum total of all of the information is material, then that is permitted. It is easy to abuse this, though, and regulators have cracked down on this practice where it goes too close to the line.
This all applies to US markets, and does not constitute legal of investment advice. Please consult your compliance officer or legal counsel if you are unsure of a specific action you want to take.