Decoding Inside Information
Executive Summary — Price setters and regulators face a difficult challenge in trying to understand the stock trading activity of corporate insiders, especially when it comes to figuring out whether the activity is a good indicator of the firm's financial future. This National Bureau of Economic Research paper discusses how to distinguish "routine" trades (which predict virtually no information about a firm's financial future) from "opportunistic" trades (which contain a great deal of predictive power). Research was conducted by Harvard Business School professors Lauren Cohen and Christopher Malloy and Lukasz Pomorski of the University of Toronto. Key concepts include:
- Routine traders, whose trades make up some 55 percent of insider trades (over half of the universe), are those with a pattern of placing a trade in the same calendar month for at least a few years in a row. Opportunistic traders are those insiders for whom there is no discernible pattern in the past timing of their trades.
- Focusing solely on opportunistic trading activity allows analysts to weed out useless signals and identify those trades that will likely predict future firm returns and events.
- More than half of the improvement in this predictive power comes from the superior performance of opportunistic sells relative to routine sells.
Using a simple empirical strategy, we decode the information in insider trades. Exploiting the fact that insiders trade for a variety of reasons, we show that there is predictable, identifiable "routine" insider trading that is not informative for the future of firms. Stripping away these routine trades, which comprise over half the entire universe of insider trades, leaves a set of information-rich "opportunistic" trades that contains all the predictive power in the insider trading universe. A portfolio strategy that focuses solely on opportunistic insider trades yields value-weight abnormal returns of 82 basis points per month, while the abnormal returns associated with routine traders are essentially zero. Further, opportunistic trades predict future news and events at a firm level, while routine trades do not.