What Is Insider Trading, and Why Is It Illegal?

Let’s say you own a failing store and have a bunch of employees working there. In the back room of the store is a temperamental boiler that needs replacing, but you just haven’t repaired it because it’s expensive and could take away the money that’s keeping your store open.

The next time a repair person comes over to look at the boiler, they tell you that in exactly two days, the boiler will definitely explode and take everyone in the store with it. Instead of telling everyone the bad news and to get to safety, you neglect to inform people, stay at home for next few days, and wait for the inevitable news that the boiler has, in fact, exploded. You escaped with your life intact, while other people met a grim fate.

This is more or less what insider trading is like. When an employee or executive at a company (an insider) has information that isn’t public and could impact the company’s stock, they have an unfair edge on investors who don’t have this information.

This is a crappy thing to do to your shareholders and your fellow employees. Plus, it’s totally illegal.

If you work for a publicly traded company, you have access to information that could impact your company’s value.

Flickr/Ian Lamont
Flickr/Ian Lamont

Therefore, you can’t legally buy or sell your own company’s stock before the news goes public. This would give you an unfair advantage.

Insider trading is when an employee or executive “in the know” pulls out of a stock before the public gets wind of bad news.


It’s also considered insider trading when that employee invests more money in the stock before good news gets out. If someone sells before bad news gets out, they would save themselves from losing money. If someone buys stock before good news gets out, they would make a profit on the news before anyone else by buying shares at a much lower price.

The Securities and Exchange Commission (SEC) is the main investigator of insider trading.

Mark Van Scyoc / Shutterstock.com
Mark Van Scyoc / Shutterstock.com

They don’t find every insider trader, but they sure as hell try to.

Penalties for insider trading include jail time and massive fines.

dnak [CC BY 2.0], via Wikimedia Commons
The risks really outweigh the benefits here.

One of the most high-profile insider trading cases was in 2002, when Martha Stewart went to jail after a hot inside tip.

David Shankbone (Shankbone) [CC BY 3.0], via Wikimedia Commons

Martha had money invested in ImClone, a biotech company.

Everett Collection / Shutterstock.com
Everett Collection / Shutterstock.com

When executives found out that they weren’t going to get one of their drugs through the FDA, they sold their stock in the company before the public got this news. Failure to get a drug through the FDA means, for a biotech company, that their stock will definitely take a nosedive.

Martha’s broker at Merrill Lynch, Peter Bacanovic, heard this news, too. Martha, Peter, and ImClone all went to jail for acting on it before the public could.

Flickr/Michael Gray

There’s a difference between trading on inside information and trading based on a perceived trajectory for a company. For instance, if your friend works for a car company, you own that company’s stock, and they tell you that the company will soon announce a recall of one of their models, the news of a recall will undoubtedly cause the company’s stock to decrease. Selling your stock before they announce the recall is insider trading.

If you don’t have any professional ties to the car company, own their stock, and notice repeated instances in the news where those cars are having problems, you can sell your stake in the company before they announce a recall. You don’t know they’re going to announce a recall; you’re simply trading on a hunch, not insider information.

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