Insider Trading Is a Lot More Common Than You Think

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You've heard the term. You've seen the headlines involving celebrities like Martha Stewart and Phil Mickelson. It has also been a focus for movies like Wall Street and Boiler Room. But do you actually know what insider trading is, and why it is illegal? Here is a breakdown of the practice that can land people in jail, and ruin careers.

What Exactly Is Insider Trading?

To be honest, it's not something that is a black or white issue. If you Google the term, you will get a result that is something like this:

"The illegal practice of trading on the stock exchange to one's own advantage through having access to confidential information."

That all seems cut and dry, until you dig into a few of the terms.

Now, an insider can be anyone who's ownership of the company stock is greater than 10% of the firm's equity, and/or someone who has access to information about the company that has not been made public.

The problem comes with the legality of how and when you use that information. There is no law against an insider buying and selling shares of the firm that he or she works for (that would be ridiculous, and incredibly prohibitive, if you think about it). As long as these transactions are logged with the Securities and Exchange Commission (more commonly known as the SEC, who regulates trades and monitors for illegal activity), it's completely fine.

However, once an insider takes undisclosed, or secret, information that he or she has and uses it for monetary gain, then it becomes an illegal activity. And in this instance, an insider is not just a person working directly for that company. It can be a spouse, a relative, a friend, or a colleague.

One of the best ways to illustrate this is from the movie Wall Street. Bud Fox is a young stockbroker, and his father works for Bluestar Airlines. During a casual conversation, Bud's father reveals some information about the company that has not been made public. Bud gives this information to the infamous Gordon Gekko, who buys stock in the company, and makes a sizable profit when the shares rise in value.

If you want another example, imagine you are chatting with a friend who works at a big company that is currently involved in a lawsuit. Your friend tells you that the lawsuit is going to be settled out of court, and the company will be fine. You go and buy shares in that company, and your shares rise when the lawsuit settlement is announced. Congratulations, both you and your friend are now involved in an illegal insider trading deal.

This, in a nutshell, is illegal insider trading. Using undisclosed, insider information to take advantage of stocks and make money. However, it is not the same as a hot tip, and that can muddy the waters a little. If you hear, through rumors or gossip, that a company like Apple or Google is going to have a great quarter, and you buy shares, you are not breaking the law. This tip has not come directly to you from an insider, and is not based on undisclosed information. It's simply a tip, like the Internet reporting that "More Spirit is a favorite to win the Kentucky Derby."

Why Is Insider Trading Illegal?

This has been debated among professionals in the industry for decades. After all…who really loses from insider trading? Someone who works at the company gives a friend some information, they buy shares, the shares go up, and everyone makes money. There's no specific loser in this scenario. That money was not stolen. It was created by the stock market.

However, insider trading creates a "rigged game." If corporate insiders use the information they have to make money, then it would lead to a scenario in which only a chosen few would make most of the profits from the stock market. This would lead to a lot of people running away from the markets, because they know they will not be able to make any money, and the entire system would come crashing down.

Basically, if insider trading were made legal, the stock market would experience a catastrophic meltdown, and businesses worldwide would be ruined.

Think of it like a casino. If you knew that some people at the Craps table were allowed to a play with loaded dice, would you bother taking a turn?

How Do You Know if You're Doing It?

Here's the part you need to be aware of; you do not want to end up like Martha Stewart.

The first question to ask yourself is, "Does this feel right?" Really, we all know when we're doing something a little shady, and although it's very easy to justify our actions, we know when something is wrong. However, if your conscience is clear, but you still want to make sure you're doing the right thing, consider the following points:

• If you are acting on information that has not been made public, you are almost certainly breaking the law. Don't do it.
   
• If you are passing on undisclosed information to someone, and they use it to make money, you are both guilty of insider trading.
   
• If you receive a tip from someone, check to see if it is based on information that has been made public. If it hasn't, you could be in trouble.
   
• If you know someone who works at a company you want to invest in, do not ask a lot of questions. You may inadvertently get them to reveal insider information, and then you will both be in a lot of trouble.
   
• If you are worried about the trade, don't do it. Or, report it to the SEC.

Have you ever been tempted to use insider information to score a win on the stock market?