A different (better?) way to track insider trading

I devoted an entire chapter in Tradestream to an investing strategy that mimicked insider trading.  You can check out my insider trading dashboard.

Data’s been really good but the methodology is being question by new research.  While previous research (specifically, that done by Seyhun in his book Investing Intelligence from Insider Trading) focused on buckets of insiders (C-level execs, VP’s, external board members, etc), new findings show that investors can get even more granular.

Like tracking individual insiders granular.follow the insiders

In Decoding Insider Information, Cohen et. al. finds that by identifying profitable, opportunistic (individual) insiders, investors can create a portfolio that yields value-weighted abnormal returns of 82 basis points per month.

Instead of grouping insiders together, this study filters out regular, noisy insider trading, of no value to investors trying to find someone trading on better information.  By looking at insiders who trade opportunistically (every once-in-a-while), piggybacking strategies can mimic just those trades that are imbued with meaningful information (assume the insider knows something.)

—> Read Decoding Insider Information (American Journal of Finance)

How to trade like insiders: building an insider trading strategy

In Tradestream your Way to Profits, I wrote about an investment strategy that follows the moves of corporate insiders.  I’ve explored tracking insider trading at a high level and have provided a list of resources for the Follow the Insiders strategy.

One thing is clear, the insider trading anomaly is alive and well in US markets and abroad (Insider Monkey) and investors can build profitable portfolios by creating a strategy that mimics specific insider trading activity.  Insiders have great information at their disposal and investors should take notice when they put their own money to work in their own companies.

The 2-tier Tradestream Model: How to Build a Profitable Insider Trading Portfolio

I created two models in Tradestream:

  1. The Muzea Behavioral Model: this is based on broker-cum-insider-trading-strategy guy George Muzea, author of The Vital Few vs. The Trivial Many: Invest with Insiders, Not the Masses.
    1. this model segments insider trading activity by looking at the behavior of the insiders and trying to get into their heads to better understand the rationale behind their trades
    2. focus on who is doing the trading: what Muzea calls Value Insiders (70% of trades done by insiders with a long-term view on their firm) and Catalytic Insiders (corporate types not concerned with book value — the insider version of a momentum trader)
  2. The Seyhun Information Model: based on researcher/professor H. Nejat Seyhun, author of Investment Intelligence from Insider Trading.
    1. Seyhun creates a hierarchy of insiders, ranking in order of their access to higher-quality, tradable information
    2. Senior Management: C-level execs who have their management finger on the pulse of their firms
    3. Officers: employees of firm but not senior enough to make decisions that affect the company as a whole
    4. Directors: Insiders who hold seats on the board of directors but are outside the firm
    5. Large shareholder: typically, institutional types who own more than 10% of the stock

The Strategy

  • Focus on active vs. passive insider transactions: insiders add/subtract to their positions for a variety of reasons and we want to differentiate between transactions based upon long-term views or merely rebalancing of existing positions
  • Buys, not sells: Selling happens all the time — insiders are always liquidating and legging out of their stock holdings (esp in tech stocks where large options rewards are common).  When this trend reverses and insiders put their own cash to work is when investors should perk up.
  • Clustering and consensus: Insider trading activity is a better indicator of future movements in the stock price when multiple insiders are buying and the same time (clustering) without a conflicting trade (consensus). (3 or more)
  • Small caps: Mirroring corporate insider buying stock in small capitalization firms is more profitable a strategy than in larger firms. (<$1B)
  • Earnings surprises: It’s a good idea to look for insider buying activity in firms that had recently reported a positive earnings surprise.
  • Bigger is better: Larger purchases are better signals than smaller ones.  (>10,000 shares)

While all of these methods improve returns, the 3 most important determinants of quality are top executives, small firms, and large trading size.

We find strong evidence that insider trades are associated with the firm’s future earnings performance…consistent with insiders trading on the basis of both security misevaluation and private information about future cash flows. — Piotroski and Roulstone, “Do Insider Trades Reflect Superior Knowledge about Future Cash Flow Realizations?” (January 2003)

How to do this

You can use some free services but it’s going to take some leg work.  Here are some great resources to monitor insider trading activity:

There are numerous others.  Let me know what you use.

photo courtesy of The Library of Congress