Some readers may have been perplexed by the title. Rest assured that I am not asking readers to do insider trades. However, I am asking readers to shrewdly follow legal insider trades. Generally, insider trades do provide a reliable up and coming shift in market sentiment on the particular stock. So what are insider trades? How do we pick the right ones to follow? These are the topics which I will be discussing below.

First, what are “insiders” and “insider trades”?

“Insiders” are broadly defined as a company’s officers, directors and any substantial shareholders of the company. Insider trading has typically been labeled with negative connotations. However, there are two types of insider trading, namely illegal and legal insider trading.

Illegal insider trading is the trading of a corporation’s stock or other securities (e.g. bonds or stock options) to reap gains or to avoid losses by those privileged with confidential information about important events. This is prohibited under the Securities and Futures Act. Legal insider trading (which is our focus here), is the trading of a corporation’s stock or other securities that does not take advantage of non-public information.

So, why do we follow insider trades?

Typically, insiders would have an idea on the health of the company and its prospects. For example, information on the company’s order flow, prospects, competition, potential risks and its financial health should be at the finger tips of senior management such as the Chief Executive Officer (CEO). These insiders are likely to have access to higher quality information and at an earlier pace than analysts, portfolio managers and almost certainly, individual investors.

According to Market Profile Theorem, an independent research firm and provider of Behavioral Financial models, integrating Insider, Earnings, Technical and Style aspects, for 20-years, found out that, on the aggregate, insider trades do signal an up-and-coming shift in market sentiment. What does up-and-coming shift in market sentiment mean? This means if there are still many insider purchases of the company’s shares from different senior management, despite the sliding share price, then this may provide a signal that the share price may reverse its decline and start to rise in the medium term.

Which are the right insider trades to follow?

Some insiders are more reliable than others

Some insiders are more reliable than other insiders, due in part to their job scopes, situational factors and track record. Firstly, a senior executive working in the Human Resource Department is likely to have less information than the Chief Operating Officer (COO) due to the job scope and responsibilities. Secondly, non executive directors are likely to have less information than key executives, such as the CEO and COO in the company. This is because key executives, through their daily management of the company’s business operations, would have the most updated information on the company’s prospects.

The other two situations depend more on situational factors. Firstly, an executive holding a financial controller (FC) designation in a small firm is likely to have more information than his peer in a big multinational firm. This is because information is more dispersed in a big organisation and only the upper management team such as the CEO has the overall picture. Secondly, some companies require newly appointed executives and directors to own shares. Thus, this kind of stock purchases by newly appointed executives and directors should not warrant too much attention as it is their company’s requirements.

Some insiders have better track record than others due to their astute ability in analysing the information and knowing what kind of information is important to the company and investors. Thus, before following an insider trade made by the CEO, your odds of being correct would increase if you can also assess the CEO’s track record in making insider trades.

Patience pays

Insiders typically react earlier and trade in advance of expected news. This is to prevent the appearance of insider trading. Thus, for investors who want to follow insiders, they should be mentally prepared to hold the company’s shares for the medium term.

The more, the merrier

The greater the number of insider trades, the higher the probability that the signal generated from the insider trades is valid. This is because a series of trades made by three of more insiders show a general consensus of opinion regarding the company’s prospects.

Insider purchases are more reliable than insider sales

In general, insider buys have generated more reliable results than insider sales. This is straightforward as typically people buy to make money. Thus, if they are willing to risk their hard earned money by buying the company’s shares, then it is likely that they have good reasons to do so.

On the contrary, there can be a myriad of reasons why insiders choose to sell the shares. Even if they feel that the company is a sound one, they may sell the shares for portfolio diversification purposes. They may also sell the shares as they require cash for housing, or for their children. Therefore, it is noteworthy that insider purchases are more reliable than insider sales.

Conclusion – follow shrewdly

Insider trades, especially insider purchases are a good starting point to further investigate a company. Therefore, readers who learn how to follow the right insider trades would likely see improvement in their portfolio performance. Nevertheless, I hasten to emphasise that readers should not use insider trades as a singular tool for the selection of investments. This should be used in conjunction with proper fundamental and technical analysis.