What is the insider trading and the regulation that relate to it?

Answer 1

Insider Trading is one where an individual with upfront information about a company or organization and its business buys the stock of that company before the news goes public thereby gaining an undue advantage over the rest of the investors.

For Ex: Let us say you are the managing director of ABC Bank Ltd which is a Stock Market listed company. After weeks of negotiation you know that ICICI bank the country's leading bank has accepted to buy your company and issues shares of its own company to investors who hold shares of your company. As any intelligent investor would know, shares of an ICICI Bank are much more valuable than shares of an ABC Bank. Once this news of ICICI acquiring ABC Bank goes public people will start accumulating shares of ABC Bank so that they can benefit out of the acquisition. This will send the price of ABC Bank skyrocketing. So, knowing this information, if you buy shares of ABC Bank for your personal share trading account before this news goes public, you can sell them off once the acquisition is complete and the share price has exploded. This way you gain an undue advantage and make a profit at the expense of the company.

This is insider trading.

So, to avoid this almost all company's have rules related to trading of its own shares by its employees especially ones that are higher up in the food chain. Employees of a company cannot buy/sell shares of their company during predetermined windows every year for ex: during quarterly financial result announcing period. This is to avoid those employees who may possess vital statistics reg. the company performance from taking advantage of this to make quick bucks in the stock market.

By now you are mumbling, what else constitutes insider trading. Let us say your brother in law or uncle is working for a large organization which is going to post impressive annual results. He tips you of the same and you buy shares of that company. Though there is no rule stopping you from buying the share because you are not its employee, it is illegal because you got the inside information from your relative who is working for them. Hence this too constitutes Insider Trading.

Or, let us say you work for a brokerage firm for example ICICI Direct and you are a relationship manager who gets detailed reports about stock recommendations to the valued customers of the brokerage house. You are only supposed to share this information with your clients and not anyone else. You cannot buy shares from your wife's account based on the recommendations or tip of your friend or relative to do the same because this is proprietary insider information which is meant strictly for the customers of the brokerage house and not everyone else. Hence this too constitutes Insider Trading.

Coming to a hypothetical situation - Lets say you are in a restaurant and a bunch of businessmen in your neighboring table are talking aloud about their company's results and expecting jump in their share prices, you go ahead and buy the share prices. Though you heard from an insider about the company and bought the share, you do not have any concrete evidence that the company is indeed doing great and the share price may go up. In all probabilities the shares may go down and you may lose your money. Since your decision to buy the share would be considered an impulsive buy based on a rumor you heard, this will not constitute Insider Trading. But do remember the fact that, you are risking your hard earned money based on some small talk you heard in a restaurant is dangerous and it could all be a bluff and you may end up losing money.

Answer 2

An "insider trade" is one made using information not generally available to the trading public, and to the detriment of the trading public.

Which doesn't say much.

So we'll say you're the CEO of Acme, and you know the plastic you make most of your products from comes only from a company that will go out of business in a month due to gross environmental violations. You bought the formula and got a different chemical company to start making it, but there will be a three-month stretch in which Acme products will be in extremely short supply because the first company can't make any more plastic--the government won't let them. This is going to kill your stock, so you sell all the Acme stock you personally hold before anyone else finds out about the supply problems you're about to have.

There's another form of insider trading called front-running. How it works is pretty simple: Stock prices go up ever-so-slightly when someone makes a large stock buy. So, a broker-dealer will take an order from Scrooge McDuck for, say, 100,000 shares of stock in the XYZ Company. He then puts in two orders. The first is for 20,000 shares of XYZ for his own account, and then the 100,000 shares for Scrooge's. When the stock price goes up a penny or so, the BD sells his 20,000 shares and keeps the profit.