Weeding out the unimportant details is half the battle

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This past week, the House of Representatives voted 417-2 to tighten the ban on insider trading on members of Congress. Given the political climate of 2012, it�s not surprising this bill passed so easily. And there is at least one congressperson — Rep. Spencer Bachus, R-Ala. — who now faces a congressional ethics hearing over alleged insider trading activities.

But investors who learn how to analyze the insider transactions among corporate executives can profit legally from that knowledge. Insider transactions are made public to level the playing field for all investors, and to prevent insiders from cashing in on upcoming major company announcements. Many of the largest financial websites, such as Yahoo Finance, carry this information routinely.

Today, we want to take a look at the basics of insider transactions, and in the process answer these questions:

Which insider transactions are meaningful and which ones are not?Which has more predictive value: insider buying or selling?How can investors use insider transactions to time their trades most profitably?What is the ratio of insider selling to buying that might predict the next bull or bear market?Buying and Selling

Insider trading is the trading of a corporation�s stock or other securities by individuals with potential access to non-public information about the company.

Insider buying, rather than insider selling, is a far more reliable indicator of future stock price direction. The reason is simple: Insiders might sell shares of their stock because they need money for a new house, a bigger boat, a fancy wedding or because they are retiring. While an expected drop in the stock price could be a motive at times, it simply is one of many reasons for insiders to sell.

On the other hand, when insiders buy shares of their company stock, it�s generally for one reason only — they have inside knowledge of their company’s prospects that they expect will cause the price of the stock to rise soon.

But having knowledge of insider buying is not sufficient to profit on a regular basis. We also need to separate the significant purchases from the ones that are of minimal importance.

Number of Shares

The number of shares being purchased by insiders is significant, and we must distinguish between automatic purchases, which could be part of a company benefit plan, and real direct market purchases.

If once a month, insider John Smith routinely buys 50 shares of his company stock, we can readily discount the significance of that purchase. Those 50 shares will be bought whether the stock is moving up, down or sideways, as he is simply accumulating shares of stock over time.

But if Smith suddenly buys $200,000 or $300,000 worth of shares, we need to pay closer attention. Furthermore, when several insiders start accumulating large numbers of shares over a relatively short period of time, investors should immediately put that stock on their watch list.

This situation occurred recently at investing firm Jefferies Group (NYSE:JEF). In September 2011, in the midst of a downturn in Jefferies Group stock, four company insiders purchased about 2 million shares each at $12.58 per share. Several weeks later, the same insiders bought another 4.5 million shares at prices between $11.35 and $11.84. Other company insiders also bought smaller yet significant amounts of shares throughout the rest of November as the price hovered above $10.

By the end of November, these transactions started to pay off. The stock took off on a strong uptrend, finally reaching a peak of $16.20 on Jan. 26, 2012. Investors who took notice of the insider buying and purchased shares of their own were treated to a 60% increase in just two months!

When Selling is Noteworthy

Just as automatic, timed purchases by insiders are of little value in forecasting stock price direction, the same is true for automatic planned sales. Insiders frequently set up these sales to occur on a specific day of the month, quarter or year, and they are labeled as such in the public records.

Although one individual insider selling shares often has no relation to the direction of future stock price, when a large group of corporate insiders begins to sell (especially within one to two months of an earnings report), that often is significant.

Most insiders are well aware of the current valuation of their stock by historical standards. Therefore, large sales by multiple insiders should be seen as a red flag.

From time to time you might be long on a stock that begins to see strong insider sales. Should you simply dump all your shares?

While that might not be necessary, a prudent investor could minimize risk by tightening their stops, or perhaps purchasing some inexpensive six-week put options as a hedge. This strategy is especially beneficial when the stock has had an extended run-up in price.

Finally, when corporate insiders throughout the whole stock market begin to sell heavily, that also is a time to consider adjusting one�s portfolio. A company called Argus Research (through Vickers Stock Research Corp.) calculates the ratio of insider shares sold to bought on a regular basis. Recently the ratio was at 5.77-to-1. Among insiders at NYSE companies, the ratio was a whopping 8.2-to-1!

Contrast this to the end of November 2011, when the stock market bottomed. That week the insider sell-to-buy ratio was a scant 0.81-to-1. The last time the insider sell-to-buy ratio was similar to current levels was in July 2011 — shortly before the S&P 500 fell from 1,350 to 1,125.

This would seem to indicate that after three months of strong price ascension, corporate insiders are becoming anxious about the lofty valuations of their own stock.

Summary

As investors we can look for — and profit by — significant levels of insider trading in a company. Looking back at our questions, we’ve determined the following:

Insider buying activity generally is more significant than insider selling, unless the selling volume is large and spread out among a number of insiders within a short period of time.Planned sales or automatic purchases have minimal value in forecasting price direction.When sell-to-buy ratios among all company insiders are historically large, that is a bearish indicator, and when the ratios are low, that often signifies a good opportunity for investors to enter the market.

Keep all these factors in mind, and insider trading figures will become a useful tool in shaping your portfolio.

As of this writing, Ethan Roberts did not hold a position in any of the aforementioned securities.