What Is Insider Trading?

What is insider trading? Insider stock trading itself isn't illegal, but a subset of insider trading is. What is insider trading, exactly, and how is it illegal in some forms?

Insider stock trading in a nutshell.
Insider trading comes in two forms: legal trading of securities of a company of which you are a part, and illegal trading based on insider information. The first type is fairly straightforward; employees are allowed to trade securities based on publicly available information and with reporting to the SEC. The illegal form of insider trading, on the other hand, is based on making trades using information that isn't available to the public.

Who is an insider?
An insider is anyone who has information that the public doesn't have yet. Say a company is filing for bankruptcy, or going out of business. An insider would be someone who has this information before it becomes public. This includes sales information, research and product development information-any information that would influence investing decisions or consumer confidence in a company. An insider could be an employee of the company, or it could be a member of a company that provides services and gains this knowledge through other means. You don't have to be employed directly by a company to be an insider.

"Temporary" insiders.
Insiders aren't just limited to companies and the people who provide services. According to insider trading laws, anyone who has material information that is non-public information that would influence investing decisions is a temporary insider, regardless of whether or not they would normally fall into the insider category.

For example, if you're a waiter at a restaurant and you happen to overhear a businessman talking about a transaction that influences your decision to buy or sell, you're a "temporary" insider. You may have no connection to the company whatsoever, but having access to non-public information that influences your investing decision makes you a "temporary" insider and bars you from making trades based on that information.

A friend of a friend.
Your closeness to the information source doesn't influence whether or not you can be considered an insider as relates to insider trading. Even if you hear information from a babysitter who heard it from a waiter who got it from his cousin who overheard it on the bus; if it's non-public, material information, you can't use it. Making a trade based on that information, regardless of how many times you're removed from the original source, constitutes insider trading and can result in severe legal penalties for you.

The penalty for insider trading varies.
The penalties for insider trading vary, and they are based on current laws. At the very least, the court can order you to return all profits you realize from insider trading, as well as impose a penalty of up to three times the amount of the profits you gained. However, some people in government are working to make insider trading a criminal charge, punishable by prison time. Regardless of the penalty, insider trading is illegal and unethical, and it can land you in a heap of trouble.