Monday, November 02, 2009

Trading on insider information is basically illegal... but where is the harm that justifies calling the foul?

Let's look at two ways in which an 'insider' takes advantage of their inside information: someone with inside information buys stock in advance of the release of good news and someone with inside information sells stock in advance of the release of bad news.

In both cases, the 'insider' gets a better price than they would had they not acted until the information become public knowledge. In the former, the insider gets to buy at a lower price, for the latter, they get to sell at a higher price. The insider certainly benefits, but who gets hurt? As counter intuitive as it might seem as the markets are often thought of as a zero sum game (in which one's gain has to be offset by someone else's loss) , just because someone benefits doesn't mean that someone else suffered.

Let's start with the insider who buys in advance of the release of good news that will drive the stock price higher. They're buying from someone who wants to sell and at a price the seller is willing to accept. The seller is not being forced to sell, nor is the seller being forced to sell at a lower price than they want, the seller is putting in his sell order at the then-current price and taking his cash to do with whatever they want. They're getting what they wanted, so how are they being hurt?

Sure, they're not going to reap the benefit of the good news, but they weren't planning on holding the stock anyway. They're losing out because the good news hasn't been made public, but they're not losing because someone else was buying on the basis of that news. In fact, the seller may actually benefit from the insider buying stock as, were that buyer not buying stock, the selling price of those shares might actually be even lower (it would depend on the amount of stock being purchased and whether it was enough to 'move' the markets, but in no case, would someone buying stock put downward pressure on a stock price).

Now let's look at the insider who sells in advance of bad news. This situation is almost a perfect mirror of the above example. The insider is selling stock to a willing buyer at the price the buyer is willing to pay. The buyer isn't paying any more than he wants to pay, he's not being forced to buy stock he doesn't want to buy. As with the above, the buyer is hurt because he doesn't know of the bad news, but he're not being hurt because an insider is selling. And as with the above, the buyer may actually be getting a better price than he would otherwise have to pay as the insider selling stock puts some downward pressure on the stock price; absent the insider selling, the asking price for those shares might be a tick higher.

So I don't see where insider trading harms the 'innocent' buyers and sellers. Anyone want to enlighten me?