How it Works
In a nutshell, it involves an individual or group that trades shares based on private company data. This allows the person/group to make a profit at the loss of other individuals in the market.
Example, John Doe is informed by someone from Company X that it lost a lot of money in the last quarter. It is totally unexpected. John decides to sell his Company X shares for $40.
A couple of days later, Company X releases their quarter earnings. The news disappoints investors and its stock value plummets to $20. While John makes a profit, everyone else sells at a huge loss.
That is the reason why insider trading is illegal. The information that John got was something not everyone was privy too. It gives him an unfair advantage over others. It also violates company ethics and rules.
ohn and his informant violated the rules by using information that wasn’t supposed to be released yet. Furthermore it is in violation of the transparency provision in the law.
Impact on the Company
But the problems mentioned above are only a part of the potential trouble. It doesn’t take long before word gets around that illegal trading has happened. When investors realize this, they will pull their money out of the company. Reeling from the bad news, Company X gets into more trouble.
That is why insider trading is illegal. It exacerbates the problem. Not only will their share value drop due to the quarterly financial report loss, but accounts of illegal trading will make things worse. Instead of making a recovery, their woes increase.
Effect on the Stock Market
This can easily create a domino effect. Assume Company X is a bank. Those who bought shares in other banks will get spooked. Even if their bank wasn’t a victim of illegal trading, they’ll sell just to be sure. When other investors see this, they’ll think that other bank shares are dropping due to illegal trade. They’ll start to dump their shares as well.
Effect on the Economy
The reason why insider trading is illegal is the effects can be so wide ranging. If a large company is victimized, the negative effects can be tremendous.
The stock market is used as a barometer of a country’s health status. Once it starts to fall, it can create panic. Foreign investments and hot money will be pulled out. This in turn can affect the currency and lead to all sorts of problems.
The scenario outlined is not an exaggeration. Keep in mind that what makes the stock market work is trust and faith in the system. Once the seed of doubt is planted, the structure can collapse like a house of cards.
It’s not enough to know the ins and outs of making money at the market. You should be aware of why insider trading is illegal too. This will keep you away from trouble.