Why is insider trading so bad?

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Why is insider trading so bad?

In: Economics

It all comes down to a sense of fairness. The general idea is that the price of a stock is based on all of the publicly available information about that particular company. Given that information, some people will think the company is over valued or under valued (hence why people trade stocks) but they are all **capable** of basing those opinions on the same set of information, so it is seen as more or less fair.

Insider trading is when someone buys or sells stock based on information that _is not_ publicly available. If you know that the company is about to have a really bad quarter, but that information isn’t public yet, then you can sell your stock right now and protect yourself from losses when that information does go public and the stock price drops (or the opposite in the case of good information). That isn’t fair to the person that is on the other end of that transaction, because they can’t know what you know so they are not capable of making an informed decision as to whether or not that trade is a good deal for them.

**Edit**: To correct, the idea of fairness is that all people in the transaction are _capable_ of having the same information. They may or may not choose to access that information, but because they are all capable of doing so, it is seen as fair. Insiders have information that others are not capable of obtaining, so it isn’t a fair transaction.

Because it cheats other investors from profits. If I have insider information that a company’s earnings are down, I can sell today for more money because most people expect earnings to be as forecast. Then next week when the news comes out, and the price goes down, others lose money – particularly the people who bought my shares.

If investors don’t believe the market is fair, they don’t want to invest. This makes less money available and shrinks the economy.

The thought was that insider trading would make your everyday people lose faith in the stock market, and they will not invest their own money into it if they think it is rigged or unfair. It’s important to note that there was never a trend in this direction, before insider trading was a crime, non-insiders still invested in the market at pretty decent rates. It was just the fear that insider trading would make people lose confidence and invest their money elsewhere that spurred those laws.

Let’s say that you are an executive for a major company. You learn that your company is going to file for bankruptcy tomorrow, and that the stock is going to tank. You have privileged information that may allow you to save millions of dollars by selling all of your company stock before the bankruptcy goes public.

If you sell your stock in such a way, you are guilty of insider trading. All of the employees and investors at any level below you don’t get this information, and may be screwed out of their retirement. You made out like a fat cat when everyone else loses their asses.

This is one of the many bad things that happened at Enron. Many executives cashed out their stock before the ship sank. They knew the company was going under because they had been cooking the books for years and lying to investors. They lied and made millions while the average guy got the shaft and many employees lost their retirement. This is why insider trading is bad, it allows the few to act on a tip while everyone else gets screwed.

Is bad for the same reason that cheating on a school exam is ‘bad’. You have an unfair advantage over your competition.