I tried researching (I’ve been watching Suits and I’m at the part when Stutter is accused of insider trading) and I still don’t understand what they mean by “making trades based on nonpublic information”. So please explain like I’m five what this really means.
In: Economics
Insider trading is trading in the stock market, based on information that is not public.
Say you work for Samsung QA, and get to know from an email from your boss that certain phone models are prone to randomly exploding.
Insider trading would be deciding to sell stocks (or short the stock) BEFORE that information becomes public (hoping that the stock goes down).
It means making trades (buying or selling) based on information that *nobody else has*.
The classic example would be something like – You’re CEO of RottenApples Inc. Your company is getting ready to release a new product next month and the stock market thinks it will go well so your stock price is at $20. However, you as the CEO know that actually the product has a major flaw and will either not go to market at all or be a major failure. Knowing that the price of $20 is as high as it’s likely to get and that once news breaks you’ll be lucky if the stock price is $5 a share you sell all your shares.
Nobody else (or at least nobody in the general public) knows that information. You have an unfair advantage.
A good example would be your the lead researcher at a pharma company that is highly valued due to the new medicine you are developing. However you just the first human test results just arrived on your desk that show it’s completely ineffective in humans.
Insider trading would be if you immediately logged in and sold teh stock you hold in the company before that information gets out and everybody sells lowering the price.
For this reason key staff members like the CEO and upper management are usually required to announce/plan buying and selling in advance. eg if you want money for a new yacht for a holiday in June you would have to announce and commit in January that you will sell x number of shares in June
Investing in the stock market is supposedly open to all and fair. Investors can look up any company they wish, look at their data, their earnings, their plans for the future, their debts, etc and make a decision based on various factors on whether they want to invest in the company or not. Big news that may affect the price of the stock are usually announced when the stock market is closed, and they’re announced publicly so that everyone has a fair chance to hear the news at the same time and decide if they want to act on those news. That’s events like plans for expansion, plans for acquisition, changing CEOs, announcing a new product or some breakthrough in the field, etc.
Insider trading is when company insiders tell their friends what the upcoming news are before they’re announced to the public so that they can take advantage. This usually allows them to open a position much cheaper than everyone else and get much better returns. They may also be warned of a potential downturn and protect their investments in time. This is not only unfair but also illegal. Unfortunately it’s very hard to catch and prove.
For example let’s say I’m a company insider in company X, with the stock being worth 20$. I tell a friend that we’re announcing earnings next month and they’re much better than previous quarters so my friend buys in. On the next day after the announcement the stock jumps 15% and most investors are lucky if they get to catch 8-9% of that. Next I tell my friend that the company will issue more shares, which generally lowers the price of shares. My friend can then sell his shares and even open a position that will benefit from the share price dropping. The next day it’s announced and the price drops 20%. For most investors holding the stock this means a 20% drop in the value of their investment but not for the guy who had insider information, he just gets richer again.
It’s not just that the information is non-public, it is not atypical for people to have more knowledge about the company they work for than a random person… it also needs to be something material (e.g. knowledge of an upcoming acquisition, or trading on quarterly results before they are announced).
If you know something about a company that the average public doesn’t know, and you trade that company’s stock based on that knowledge, insider trading.
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