Mimicking Insider Trading
Introduction
Much of the field of finance is focused on creating abnormal returns—that is to say, returns that are different from what one might expect them to be based on various characteristics of the investment—by identifying so-called “inefficiencies” in the stock market. Perhaps one of the most well-known strategies for taking advantage of these inefficiencies, a strategy widely discussed in academic as well as industry literature, is following the trades of company insiders.
In the United States, company insiders are required to report to the SEC any time they engage in a purchase or sale of their firm’s stock, within two business days following the date of the trade. This information, once reported to the SEC, is subsequently made available to the public almost immediately, allowing outsiders to see exactly how insiders are trading. When insiders trade based on material non-public information and earn abnormal returns, it is a violation of the strong form of the Efficient Market Hypothesis, which itself is not backed by any significant empirical evidence. However, if outsiders are able to earn abnormal returns by mimicking insider trades, this becomes a violation of the widely-accepted semi-strong form of the Efficient Market Hypothesis, which states that the price of a stock incorporates all publicly available information.
The academic literature contains many studies which attempt to generate excess returns by replicating insider trades, with varying degrees of success. While some early studies (Jaffe 1994, Finnerty 1996) claimed that outsiders were indeed able to create a small amount of excess returns, a later study by University of Michigan Professor H. Nejat Seyhun concluded that once these trades accounted for transaction costs, the excess returns would be nearly zero. Later studies by Rozeff and Zaman (1988), Lin and Howe (1990) and Friederich, Gregory, Matatko and Tonks (2002) have also reaffirmed that transaction costs depleted all the excess
Much of the field of finance is focused on creating abnormal returns—that is to say, returns that are different from what one might expect them to be based on various characteristics of the investment—by identifying so-called “inefficiencies” in the stock market. Perhaps one of the most well-known strategies for taking advantage of these inefficiencies, a strategy widely discussed in academic as well as industry literature, is following the trades of company insiders.
In the United States, company insiders are required to report to the SEC any time they engage in a purchase or sale of their firm’s stock, within two business days following the date of the trade. This information, once reported to the SEC, is subsequently made available to the public almost immediately, allowing outsiders to see exactly how insiders are trading. When insiders trade based on material non-public information and earn abnormal returns, it is a violation of the strong form of the Efficient Market Hypothesis, which itself is not backed by any significant empirical evidence. However, if outsiders are able to earn abnormal returns by mimicking insider trades, this becomes a violation of the widely-accepted semi-strong form of the Efficient Market Hypothesis, which states that the price of a stock incorporates all publicly available information.
The academic literature contains many studies which attempt to generate excess returns by replicating insider trades, with varying degrees of success. While some early studies (Jaffe 1994, Finnerty 1996) claimed that outsiders were indeed able to create a small amount of excess returns, a later study by University of Michigan Professor H. Nejat Seyhun concluded that once these trades accounted for transaction costs, the excess returns would be nearly zero. Later studies by Rozeff and Zaman (1988), Lin and Howe (1990) and Friederich, Gregory, Matatko and Tonks (2002) have also reaffirmed that transaction costs depleted all the excess
References: (1)http://www.ukessays.com/dissertation/literature-review/empirical-analysis-of-legal-insider-trading.php (2) Decoding Insider Information, Lauren Cohen, Christopher Malloy and Lukasz Pomorski, March 23, 2010, P.15 (3) Investment Intelligence from Insider Trading, H. Nejat Seyhun, 1998, P.334 (4) Investment Intelligence from Insider Trading, H (9) Historical Trends in Executive Compensation 1936-2005, Carola Frydman and Raven E. Saks, January 18, 2007 (10) https://gupea.ub.gu.se/bitstream/2077/36369/1/gupea_2077_36369_1.pdf