Is insider buying a meaningful indicator of future stock price?

Traders and investors use all types of technical and fundamental indicators in the attempt to predict future price action with insider trading being one that falls into the latter category. What is insider trading and can it be used as a tool to predict future price action?

The answer to the first question is that there are two types of insider trading—legal and illegal, although the line between them can sometimes be blurry. If you’re an officer of a company, a member of the company’s board of directors, or hold more than 10% of the company’s stock, the SEC considers you an insider and as such you are required to file a Form 4 with them when you buy or sell positions in your company’s stock. This public disclosure is the government’s way of legitimatizing insider stock trading.

Certainly, the legalities of insider trading can make for an interesting discussion but my focus today is to answer the second question: Can insider trading be used as a tool to predict future price action?

Does insider buying presage an increase in stock price?
The general theory is that if insiders are trading their stock, they may be doing so on some special knowledge such as an especially good or bad upcoming earnings release, favorable or unfavorable drug study results, or the company is involved in takeover talks. Trading on this type of information is illegal but in most cases it can be very hard to prove, and the SEC just doesn’t have the person-power to look into every such instance of possible abuse.

Is this general theory accurate? In the attempt to answer this thesis, I decided to look at the top insider purchases from the middle of May to the middle of June of this year (2009). I included the top insider trades made by company officers and directors and disregarded those with a 10% or more interest (mostly private equity firms and mutual funds) on the assumption that these outside firms would not be privy to the same information as the company’s insiders. Ideally, I would have liked to include only those trades made by the CEO, COO, and CFO, but that would have drastically limited my sample space.

Here’s a table of the top 24 insider trades made during this time period. Note that some trading days are absent due to the lack of insider trades. Also note that each trade represents a single purchase made by only one individual. [Click on table to enlarge.]

insider-buys-7-16-09

Observations
We can see from the above table that if insider buying has any influence on stock price, it only extends for a couple of weeks at most with the average gain being only a modest 4%. This increase could arise not only from improving company internals as perceived by the insider, but also from external market conditions. As shown near the top of the chart, the S&P 500 increased from the middle of May to the middle of June–also a gain of 4%. And when it turned back down, the average insider gain turn into a loss.

Certainly, a larger sample space taken over a longer time-frame would give us more confidence in these numbers, but I do think that even with this limited data set we can see that purchasing stock along with company insiders may not be the most profitable way to invest.

In an upcoming article I’ll test whether or not insider selling can be used to predict stock declines.

Note: I reviewed the news on the largest movers (BID, ECLP, OSG, VVTV) to see if there were any significant reasons for the increase in price following insider buying but I couldn’t find anything that I thought was compelling.

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