When many investors hear the words insider trading they may immediately think of “illegal” insider trading. Names like Martha Stewart may come to mind. And it’s true that insider trading can be illegal. However for insider trading to be illegal, the insider must be trading on information that has not been released to the general public.
There are three conditions that have to be met for an act of insider trading to be illegal:
Information must be passed along by an insider.
The individual(s) receiving the information must act upon (traded) that information.
The trading activity must take place before the tipped information is available to the general public.
That last point is essential to understanding insider trading. In many cases, the information used for a trade becomes public knowledge. The point is that if an individual were to find out something days or weeks before the general public, they could prepare a trade to maximize their own gain.
There is another factor to consider. The insider trading must be based on information that is certain to impact the shares of a stock. This might include learning about the passage of a bill through Congress or getting a heads up that a company’s drug or therapeutic passed a clinical trial phase.
The takeaway is this. If you work inside a company, you’ll have access to information that retail investors don’t have. But as every investor knows, sometimes an instinct is just an instinct. Insiders can get it wrong just as easily as retail investors. That doesn’t make it insider trading.