Mistakes to Avoid When Relying on Insider Trading Data

Insider trading data can offer a glimpse into the decisions and confidence levels of company executives, directors, and large shareholders. However, some misunderstand or misuse this information, leading to poor investment decisions. In this guide, we’ll look at common mistakes investors make when relying on insider trading data and offer tips to avoid them.

What is insider trading data?

However, not all insider trading is illegal. Executives and board members can legally buy and sell shares of their companies, but they must disclose these transactions to the Securities and Exchange Commission (SEC). Investors often use this data to try to predict the confidence insiders have in the future of the company.

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That said, while insider trading can offer insights, there are a few mistakes to watch out for. So, let’s check these out, shall we?

#1: Misinterpreting the purpose of insider transactions

The first common mistake is assuming that all insider buying is a sign of future stock appreciation and that all insider selling indicates trouble ahead.

Insiders buy and sell shares for a variety of reasons, not all of which are related to the company’s future prospects. For instance, an executive might sell stock to diversify their portfolio, fund a personal expense, or comply with a pre-arranged trading 10b5-1 plan.

On the flip side, buying might not always mean they have insider knowledge of future growth. Insiders could merely believe the stock is undervalued but still be wrong about the company’s future performance.

In fact, research supports the idea that insider buying isn’t always a surefire predictor of stock performance. A 1986 study by Seyhun analyzed insider trading patterns and found that while insider buying can sometimes signal future growth, it isn’t always reliable. Insiders may buy because they believe the stock is undervalued, but even they can misjudge the company’s future performance.

#2: Ignoring the insider’s role in the company

Next up, we must say that not all insiders are equal. For instance, a CFO’s stock sale may carry more weight than a mid-level executive’s, given that the CFO has a closer understanding of the company’s financial health. Unfortunately, investors often fail to consider the insider’s role in the company when analyzing trading data.

An insider close to daily operations or the company’s finances might provide more reliable indicators of a company’s future than someone in a less critical role, like a board member who only attends quarterly meetings.

#3: Overlooking the size and frequency of trades

The third common mistake is focusing on a single trade without considering its size or frequency.

Namely, a $10,000 buy from a CEO might not be as significant as a $500,000 purchase from the same individual. Likewise, multiple small trades over time may indicate more confidence than a single large transaction. The more significant the insider’s stake in the company, the more confidence the trade will show.

“Insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise.” — Peter Lynch, famous investor

Investors should also be aware of patterns of trading over time. Consistent buying over several months may indicate growing confidence, while sporadic buying and selling could suggest other factors at play.

#4: Failing to analyze external factors

Sometimes, insider trades are motivated by external factors unrelated to the company’s future performance. Investors often overlook these external influences, which can lead to faulty conclusions. For example:

• Market conditions: Broad market declines or rallies can drive insiders to buy or sell stocks;

• Tax planning: Insiders may sell shares to cover tax liabilities;

• Pre-arranged trading plans (10b5-1 plans): These plans allow insiders to set up automated sales ahead of time, meaning the timing of the sale may not be influenced by recent company news;

#5: Neglecting insider ownership levels

Finally, one of the biggest mistakes investors make is not considering the insider’s total ownership in the company.

A CEO who owns 5% of the company and sells 1% of their shares might not indicate a lack of confidence, but rather rebalancing their portfolio. On the other hand, if a high-level executive who owns a small percentage of the company suddenly sells half of their shares, it could be a red flag.

A quick recap of the common mistakes to avoid

1. Assuming all buying is positive and all selling is negative;
2. Ignoring the insider’s role within the company;
3. Overlooking the size and frequency of trades;
4. Failing to consider external factors;
5. Neglecting the insider’s overall ownership levels.

The bottom line

In summary, insider trading data can be a useful tool in making investment decisions, but it must be analyzed carefully and within context.

You should, therefore, avoid the mentioned mistakes by understanding why insiders might trade, who they are, and the broader circumstances affecting their actions. Such a careful analysis can help you use insider trading data more effectively and avoid costly errors in your investment strategy.

Furthermore, to make better use of insider trading data, consider subscribing to Finbold Signals, which delivers real-time updates on insider transactions, helping you track patterns and make more informed decisions.

Disclaimer: The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.

FAQs about common insider trading mistakes