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Insider Trading is Unfair (But Should it be Legal?) - How Money Works - YouTube
Channel: How Money Works
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Insider trading is the act of making financial
trades based off of information that is not
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openly available to the public.
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For example a CEO buying shares in their own
company because they know that the business
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is about to publish record profits would be
insider trading.
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Once this report becomes available to everybody
more people will want to purchase the stock
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increasing the price and making the CEO a
healthy profit with very little risk.
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It doesnât even need to be a CEO.
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Sometimes even entry level analysts are privy
to potentially market moving information,
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at the end of the day, itâs not going to
be the CEO writing up quarterly reports.
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This can create opportunities for people to
make more than their annual salary by simply
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buying up some call options and waiting for
their report to go public.
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Someone with a consistent flow of insider
information on a single publicly traded company
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could easily make triple figure annual returns
which could make even an investment of a few
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thousand dollars turn into millions very quickly.
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The problem is, that this practice is illegal.
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I think most of you already knew that.
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But, should it be?
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It was only actually outlawed in 1934, and
back then it was only done to stop company
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executives taking advantage of the market
turbulence of the great depression.
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So whatâs the harm?
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How does one executive making a bit of money
equate to everybody else loosing money?
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Especially since they are making those trades
with willing counter parties who would have
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traded those stocks with someone else if not
for them.
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So itâs time to learn how money works to
find out if insider trading laws actually
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achieve anything, and to see why the abolishing
these laws could lead to more efficient and
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stable markets in the long term.
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Again I find myself making a video on literal
financial fraud which is obviously not very
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advertiser friendly, fortunately I can keep
making these videoâs thanks to the support
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I receive from my channel members and patrons
on Patreon, so thank you guys.
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âŠ
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The tricky thing about insider trading is
knowing exactly where to draw the line.
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There are extreme cases which are obviously
illegal, such as the rogue ceo or analysts
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that we used as an example at the beginning
of this video but some are harder to say for
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sure.
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I should add at this point of the video that
I am not a lawyer, so donât be going and
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telling the SEC that I said any of this was
legal or illegal.
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Even if I was a lawyer itâs impossible to
say for certain where the line is drawn in
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a given case, which is actually part of the
problem.
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Consider this example.
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You walk into a five star restaurant and you
are sat next to a CEO and a CFO of a large
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public company.
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The pair get a little drunk and start talking
openly about how big their bonuses are going
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to be once their annual sales figures are
releases to the public.
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This sounds like good news so the next day
you buy up shares in their company and sure
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enough a week later once quarterly profits
are made public the stock rallies 20% based
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off of the promising figures.
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Is this insider trading?
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On the surface it looks to be, you had access
to information that wasnât openly available
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to a general member of the public.
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You used that information to make an informed
financial decision and you profited off of
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doing so.
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Even if this isnât insider trading for you,
would it count as insider trading for the
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careless CEO who indirectly divulged this
information?
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Well⊠actually⊠no, it would not, thatâs
because even though the average investor would
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not have been lucky enough to come across
the information you gathered by being sat
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next to these two loud mouths, it was still
announced to the public albeit in a very limited
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forum.
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Ok but what about if those tables were pushed
together, suddenly the CEO the CFO and you
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were all having dinner together and the same
conversation took place.
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Then that would be insider trading because
you would be deemed as someone personally
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selected by an insider to have access to a
forum where market moving information is discussed.
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Well ok, what happens if we assume the CEO
and CFO are strangers in a restaurant again
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and we are just sitting next to them.
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Instead of discussing a annual profits they
are discussing a corporate that they are planning
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to announce the next week.
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You buy up stock in the company they are planning
to take over and once again the value of the
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stock rallies and you make a healthy profit.
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Sounds the same as the first example right?
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You just happened to overhear something in
a public place.
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Well this unfortunately would be insider trading
because information regarding mergers and
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acquisitions is held to a higher standard
by the SEC and there is the reasonable expectation
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for all marker participants that this information
is not public until it is formally announced.
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Letâs consider another slightly morbid example.
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You are the member of a very prestigious golf
club, you are hanging out on the 10th hole
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when you see a very influential CEO of a public
company fall dead of a heart attack on the
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11th.
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After (hopefully) calling an ambulance you
open up Robbin hood and short the stock of
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that company?
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Would this be trading on insider information?
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I am actually going to let you all discuss
that one in the comments section, I need that
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video engagement, but donât worry we will
work it out together by the end of this video,
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you know I wouldnât leave you guys hanging
like that.
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Alright, final hypothetical here.
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Letâs say you and your sister were math
and science prodigies growing up.
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Your used her talents to become the CEO of
a fortune 500 tech company.
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You on the other hand used your talents to
try an beat the markets as a day trader.
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You never trade on any information your sister,
or her associates share with you but you do
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trade stock in her company as well as other
competing companies since technology is the
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field that you know best.
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your high performance arouses suspicion from
the SEC and both you and your sister are charged
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with insider information.
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How do you prove you are innocent?
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The legal burden of proof lies with the prosecutors,
but by that time she might have lost her job
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and brokers may decide not to work with you.
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Hopefully you can see through all of these
examples that drawing the line of what insider
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trading is, and is not, is incredibly difficult.
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In reality no two parties ever have access
to identical sets of information when making
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a trade.
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A regular investor looking at Robinhood on
their phone is not going to have access to
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the same information as a managing director
on a Goldman Sachs trading floor.
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Artificially just restricting some people
from making trades simply makes something
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called price discovery slower.
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Price discovery is the process of markets
slowly finding the ideal price for an asset
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through people selling it when the price is
too high or buying it when the price is to
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low.
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In theory having a market price which is perfectly
realized means that the price would be truly
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indicative of the underlying value of the
asset.
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It might sound like financial jargon but imagine
if you could buy and sell shares knowing that
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the price on offer is perfectly fair based
on all information.
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It sounds great but regulation against insider
trading as well as other laws that hold back
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trading activity prevent that from ever being
perfectly achievableâŠ
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âŠ
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Now price discovery and legal grey areas are
far from the main argument coming from supporters
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of insider trading.
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Those issues pale in comparison to the fact
that insider trading happens all the time,
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and itâs practically impossible to stop
at least 50% of it at minimum.
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This is not some rant about how the SEC is
underfunded or anything like that, even if
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the agencies in charge of cracking down on
this kind of behavior had all of the money
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and manpower in the world, they could still
not stop 50% of insider trading.
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This is because of what is called omitted
trades, or trades that insiders choose not
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to make.
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Letâs think back to our humble analyst again
putting together a company report which is
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going to deliver some kind of good news to
shareholders.
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Because they are not deemed important enough
in the corporate hierarchy, they do not need
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to publicly disclose their trades nor do they
need to plan them ahead of time like the senior
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executives do.
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Well letâs say that this analyst was trying
to decide if they should sell the shares that
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they were given as part of their bonus last
year.
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Once they start working on the report, they
realize that these shares are going to be
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worth a lot more in just a few weeks so they
instead decide to hold onto them to wait until
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they are worth more money and reassess what
to do then.
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This is making trade decisions based on insider
information
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The reverse is also possible.
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If an analyst WAS going to buy shares in the
company they work for but then change their
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mind because they start working on a report
that is going to deliver very bad news then
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this too is making trading decisions based
off non public information.
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This is technically illegal and itâs why
senior executives in America need to declare
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their trading plans months in advance, but
unless you extend this requirement to all
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employees or start prosecuting literal though
crimes itâs impossible to stop this happening
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amongst every other insider in the business.
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âŠ
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So insider trading helps markets operate efficiently
while being almost impossible to police and
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difficult to prosecute.
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Why do these laws exist then?
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Who does insider trading actually hurt?
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Well itâs not good enough to just say âregular
investorsâ because thatâs not actually
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true.
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Insider trades need to be made with a willing
counter-party.
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Nobody is holding a gun to the head of a regular
investor and forcing them to sell their shares
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to a corporate insider.
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The regular investor and the insider agree
on a price that they are both happy with.
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The regular investor on the other end of this
trade would have no way of knowing who that
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person was, and they wouldnât magically
be any worse off as compared to a reality
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where they just sold their stock to another
regular investor.
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People holding the stock wouldnât be any
worse off either.
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If the company is about to announce good news,
then they will do well, if the company is
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going to announce bad news then they will
do poorly.
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A few insiders trading on this news before
it goes public is not going to change the
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inevitable.
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On the contrary these insiders might make
the decline in price more gradual avoiding
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some of the emotional trading that can be
caused by public announcements.
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Alright in the interest of fairness there
is one legitimate issue cause by insider trading,
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and that is that it can stifle market activity.
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To demonstrate this in a simple way imagine
that you had a stock market with only two
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participants, yourself and some corporate
insider that knows everything going on in
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all of the companies listed on the exchange.
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Now consider this insider puts up an offer
to buy some of your shares.
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Would you sell them?
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The logical answer is no, because this insider
is only offering to buy those shares because
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they know they will be worth more soon based
on some kind of information they have but
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you donât.
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As with all of these examples the same is
true in reverse.
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If they offer to sell you shares you should
not buy them because they are only going to
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offer to sell you something if they know itâs
going to be worth less in the future.
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This would cripple market activity and make
it impossible for anybody to accept any trade
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without loosing out to an insider.
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Except it probably wouldnât.
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In a market with just two participants sure,
but in a market with millions of participants
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and no way of telling who is an insider and
who isnât, this really wouldnât be an
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issue.
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There would be one group that would miss out
however, and that is the speculators.
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People (or much more commonly institutions)
that make trades based of a stock being undervalued
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or overvalued would find it much harder to
make profitable these trades successfully
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in a market where price discovery was more
efficient.
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Would it be worth loosing hedge funds and
day traders in exchange for knowing that the
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stocks we buy are not going to be drastically
altered by some report sitting on a desk somewhere?
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Iâll leave that up to you to decide.
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Now if you are still thinking about making
a trade as the golfing CEO gets shipped off
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to the morgue then fear not, what you did
was morally reprehensible but perfectly legal.
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If you enjoy moral reprehensibility in the
name of profit then you will love my video
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detailing exactly how Jordan Belfort made
his million in the wolf of wall street.
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Thanks again to my channel members and patrons
on Patreon for making it possible for everybody
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to keep learning how money works.
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