Insider Buying (Part 3): More Tips
Insider buying data has shown to be a good indicator for future stock price appreciation but it is not a fool proof system. From reading the introduction to some of the online trading websites and trading tools that advocate insider buying, it would seem that if an insider is buying, you should follow along blindly. The fact is, not all insider buying is good insider buying and you need to know how to tell the difference.
Like Peter Lynch says, “insiders buy for only one reason: they think the price will rise.” The key word in that statement is “think,” because it means they strongly believe there stock will rise but they do not know. Here are some examples of insider buying that investors should be careful about:
- Biotech stocks. Insiders at a biotech companies are often confident about their prospects but they don’t know what the FDA will say when it comes to approving their drug.
- Penny stocks. These typically aren’t good investments because the overall dollar amount that insiders commit is not substantial despite the large number of shares. Furthermore, penny stocks are notorious for their high risk levels because they are small and illiquid.
As an investor, you need to understand why an insider is buying shares of their company. If they are consistently purchasing shares, this definitely instills confidence in the company for the long term. This does not, however, promise the short term gain that may follow from a large, single purchase that can be an indicator of pending news.
Insider buying reports will often show buying from groups with greater than 10% ownership. These are not actual insiders but are usually hedge funds, high-worth individuals, and institutional investors. These professional investors are also considered “smart money” because they usually have good research, advice, and connections. The way they invest, however, can throw an observer off because professional investors never make one single purchase at one price. They often cost average down and can afford to take huge losses for long periods of time in hopes of a long term gain.
A perfect example is when insider buying data is showing professional buying that has been consistent for months but the stock keeps falling. As you’ll often see, consistent insider buying does not necessarily make a great buy. These professional investors have deeper pockets than most of us, so they can keep buying for a long time, even if the stock keeps falling. This type of buying can be tracked for a decision in the future but it should be avoided for now.
Sometimes the insider buying information is not an actual purchase of the shares in the open market but actually an exercise of stock options. This can be determined by looking at the stock price and time the insider bought at. If the share price he bought at is much lower than the share price was trading at for that date, you now know that it was an exercise of options and not an actual buy. I have seen professional business reporters, analysts and insider buying websites misinterpret this information. This is a huge error because most insiders that exercise their stock options expect to sell their shares in the near future in order to lock in their profit.
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