Making investment decisions using information that should be confidential is called insider trading. It is a criminal offence in most countries, although the effectiveness of enforcement varies from country to country. The reason it is regarded as sufficiently harmful to merit strong deterrents are:
- It is unfair on investors who do not have access to the information.
- It may deter investors from participating in the market at all, undermining the basic purpose of markets, which is to allow companies to raise capital.
- It may destabilise markets by encouraging rumours.
- It intrinsically involves profiting from a breach of confidence, at the expense (at least partially) of people to whom the insider has a duty (such as their employer, and their employer's shareholders).
Defenders of insider trading claim that it improves market efficiency by allowing secret information to influence prices. In fact some sort of leaking of information would be necessary to bring markets anywhere near strong form efficiency. The consensus view is that insider trading is highly damaging.
Because insider trading is illegal, insiders who wish to exploit price sensitive information, collaborate with traders to make it harder to trace the trades back to the person who is known to have access to the information. This is called an insider ring.
Not all information that is not publicly available is likely to be defined as insider trading, but anything that can reasonably be expected to have a significant effect on a company's share price is. The source of the information and the way in which is was acquired also affects the legality of trading on it.
Investors should be cautious about using any information that is not publicly available: not only may it put them in jail, but rumours and "tips" are often fabricated by those trying to manipulate the markets.
Investors can sometimes, perfectly legally, get an edge over others by ensuring that they make use of all possible sources of information.
- Not all published information is necessarily used by all investors.
- Information that is not technically price sensitive may be useful but not well circulated. A frequently useful example is information of a technical nature rather than related to finances or sales.
- Information related to other companies (other than the one whose shares are being dealt in) may be useful but would not be inside information.
This means that investors may be able to legally gain an edge by doing more research than others and digging up information that is not generally known. In particular doing research on, and understanding, sectors and industries as well as companies can tell investors a lot.
Investors who do have access to confidential information are well advised to be cautious and to get appropriate professional advice when in doubt.