Skip to content

Mistakes to Avoid When Relying on Insider Trading Data

Mistakes to Avoid When Relying on Insider Trading Data
Bogdan Stojkov

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?

Insider trading refers to individuals with non-public, material information about the company buying or selling that company’s stock.

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.

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?

Mistakes to Avoid When Relying on Insider Trading Data
Common mistakes when relying on insider trading data. Source: finbold.com

How to track insider trades?

Insider trading for companies listed on U.S. stock exchanges is required to be reported to the SEC and can be found in the EDGAR database. However, due to the high volume of reports, using a tool like Finbold Signals can make it easier to track and follow significant insider trades.

#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.

Key takeaway

Don’t assume that insider trading is always a clear signal of a company’s future. Look for patterns over time rather than making decisions based on one or two trades.

#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.

Insider's role in insider trading signal
Insider’s role in trading signal. Source: finbold.com

Key takeaway

Evaluate the insider’s position in the company. High-ranking executives may provide more meaningful signals than less involved insiders.

#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.

Key takeaway

Look for consistent, large-scale transactions that align with the insider’s wealth and the company’s overall stock performance.

#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;

Key takeaway

Always consider external factors that could be influencing an insider’s decision to trade.

#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.

Ownership levelSignificance of insider trades
High ownership levelsInsider trades are more significant when insiders have large stakes in the company.
Low ownership levelsSelling a small stake may not carry much weight.
Table 2: Comparison between high and low ownership levels and their significance in insider trading analysis.

Key takeaway

Always consider insider ownership levels when analyzing their trades. Large ownership suggests more skin in the game and higher significance when they make moves.

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

What is insider trading data?

Insider trading data shows stock transactions made by company insiders, such as executives and directors. These trades are reported publicly.

Is insider trading always illegal?

No. Legal insider trading is when insiders report their trades publicly. It becomes illegal if they use non-public information for personal gain.

How can insider trading data help with investing?

It can signal insider confidence in the company’s future. However, it’s important to analyze trades in context to avoid misinterpretation.

Is insider buying always a good sign?

Not always. Insiders might believe the stock is undervalued, but that doesn’t guarantee future growth.

What makes an insider trade significant?

Look at the insider’s role, the size and frequency of trades, and their overall ownership in the company.

What are 10b5-1 trading plans?

These pre-arranged plans allow insiders to sell shares on a schedule, meaning trades may not reflect their current views on the company.

Finance Digest

By subscribing you agree with Finbold T&C’s & Privacy Policy

Related guides

Contents

Sign Up

or

By submitting my information, I agree to the Privacy Policy and Terms of Service.

Already have an account? Sign In

Disclaimer: The information on this website is for general informational and educational purposes only and does not constitute financial, legal, tax, or investment advice. This site does not make any financial promotions, and all content is strictly informational. By using this site, you agree to our full disclaimer and terms of use. For more information, please read our complete Global Disclaimer.