Insider Buys – Methods and Strategies

For those wishing to learn about insider buying trading, I’ve consolidated three posts on this topic, to provide an easy way to find all the information in one place.

Insider Buys – Methods and Strategies

By Ilene and Dave

A generally reliable stock-trading strategy is to buy a stock when an insider has just reported a significant purchase to the SEC.

The theory is simple: the insider knows the stock is undervalued and/or knows there is good news on the way which will move the stock price up, and believes this move will be sustainable.

There are a number of services which notify subscribers when an insider buys stock in a company. Some services provide notification within minutes, transmitting the information to subscribers via email alerts.  Insider Cow, which is allowing us to tap into their service, allows subscribers to choose which insider actions they wish to be alerted to.

Not all insider buys have the same ability to move a stock – some are recognized as meaningful and will attract traders and investors, while others are virtually ignored. Distinguishing between meaningful buying and insignificant buying is part of successfully trading this strategy. To complicate the matter, the meaningfulness of an insider buy – measured by the market reaction to it – is influenced by an ever-changing market environment.

When I began trading this strategy, about four years ago, I was using a software program developed by a friend which would access the SEC website and alert us when an insider filed a buy.  The program would attempt to determine how bullish the purchase appeared to be.  It would do this by calculating a score based on the available information.  For example, if a CEO of company with market capitalization less than about $1 billion would buy $1 million dollars worth of stock, the program would toss out a relatively high score indicating that buying the stock was likely to result in a profitable trade.

Beginning around two and a half years ago, this method became more difficult to trade due to changes in day-trading patterns and market conditions. The first change we noticed was that we were losing our competitive edge. Faster, larger players (programs?) were buying substantial quantities of stock before us, and then they (or it – we called it “Big Foot”) would liquidate into a run up, making it difficult to reliably get in and out with a profit. The result was that “marginal trades” stopped working. The charts were revealing. There was often a quick spike in price and volume, minutes before our software program gave an alert. Soon after, the stock would hit a wall of selling pressure as though sellers (Big Foot) were dumping huge quantities.

Secondly, the overall condition of the market also began changing.  Trades based on insider buying – day-trade or longer term – are influenced by market conditions. When the broad market is selling off, being ultra-selective is especially important. Today, selective evaluation of insider buys is a prerequisite for successfully employing an insider buying strategy. While there may not be many excellent insider buying opportunities, especially when the market is weak, there will be some and we can take advantage of them.

Let’s begin by examining what to pay attention to while contemplating taking a position in a stock after an insider has bought it.

Variables – factors to consider, based on past observations:

• Price – the insider buy price should not be much lower than where the stock is currently trading, e.g., if the insider bought stock for $6, don’t pay $9. You might still pay $6.50. It’s a judgment call. If the insider was a CEO or CFO and the dollar amount of the purchase was very large, you might want to pay up more than usual.
• Liquidity – look at the chart, a lot of choppy stairs on the daily chart is a warning. Example: stock trades less than 100,000 shares a day, and you buy 5,000 shares 20% higher than it was when it first started running. Chances are pretty good that the stock will reverse and start dropping. The traders/programs that got to it faster than you are racing to get out with their day-trade profits. By the time you figure this out (having failed to look at the daily chart), your stock may be down 25% (yes, down more than it was ever up). Getting out with a small loss becomes a long-term project and you hope the insider buyer was expecting good news in the immediate future.
• Dollar value of the purchase – this criterion has become more important in the last few years.  It used to be that if an insider/officer bought over $100K of a sufficiently liquid stock, there was a good chance the stock would hold up and be up again the next day. This doesn’t seem true anymore. I’d move the threshold for amount of purchase up to around $200K. Holding overnight has become more risky as well.
• Market Cap – over $100-$200 million to $1 billion is around the optimal range. If the market cap is too small, liquidity problems are likely. If the market cap is too large, the insider buy will have a negligible effect on the stock price.
• Buyer’s Identity – CEO and CFO are best, other officers next, then directors, then 10% owners (10% owners do not typically move stocks).
• Sector – some sectors are better than others. Companies in the technology sector were often the best movers. Energy stocks and REITs were among the worst.
• Number of shares. Strangely, this was an independent variable which had a significant effect on stock performance. Intuitively, it would seem to be a reflection of purchase amount and market cap. Perhaps, the independent significance of number of shares reflected the influence of traders who would only buy if the number of shares purchased was as at least 3,000.
• Market Conditions – if the market is weak, the insider buy has to be more meaningful to generate a reliable trade.  For instance, in a weak market, I’d like to see larger purchase amounts, a CEO or CFO buying, and market cap and liquidity within tighter ranges.

Most of the potential insider-buy trades in a weak market are unpredictable. However, if an officer is buying a substantial amount of stock (e.g. million dollars worth), these trades are usually fairly safe. The reason is probably that in a bad market, others trading this strategy are also more selective. However, if the insider buy is large enough, there’s an effect beyond the transient momentum of day-trading.  

Here a few notes from Dave Borland.  Dave has been trading insider “i-buy” stocks for around eight years.  These notes were taken from a conversation we had several months ago. – Ilene
 
1.  Score 
 
The software program Dave uses to monitor the SEC filings generates a score mostly as a function of who’s buying, dollar amount purchased, and market capitalization of the company.  Dave was primarily responsible for setting up the algorithm for determining the score. 

If you spend time watching how stocks trade after a large insider buy has been filed with the SEC, you’ll begin to see common patterns.  For significant buys, the stock will start running often before you get the information. Time is particularly important for day-trading.  A high score indicates that there’s a high probability that the trade will be successful. Currently, using this particular scoring system, 53% and above is a signal to buy, less than 51% probably won’t work.  The cut off changes with market conditions.  
 
2.  Commodity Based Stocks
 
Dave: “I learned years ago to be extra wary of commodity based stocks for buying and holding.  Earnings are very dependent on commodity prices, and insiders may not be able to forecast these any better than stock investors can.  There are cases where a commodity stock plunges with commodity prices, then the insiders pile in because they know of sources and contracts with locked in prices.  So the external market force that caused the plunge actually doesn’t apply to them.  But don’t count on that being the case.”
 
3.  Housing/Mortgage Disaster 
 
Dave:  “I think any book written about the current housing/mortgage disaster should have a chapter dedicated to all the insiders who seemed to truly disbelieve it even when it was happening.  A lot of bank and homebuilding insiders were loading up on stocks that had fallen from $40 to $20, only to see them go to $5.  IndyMac insiders were buying big in Feb or March at $3-4, only to see the bank collapse in July.”
 
4.  Good Old Days
 
Dave:  “Remember the good old days when this crummy i-buy at TASR would be good for $300?”   [RTIX, PWER, TUNE, ORCH, TASR…] – “the underlying principle here is that those [small $ amount] i-buys aren’t likely to signal anything, though we used to make $200+ on junk like that all the time.
 
“Another change from the past: for many years, banks never worked.  Now, they sometimes do because an i-buy can be a major positive sign at a bank in distress.  But unfortunately, an amazing number of insiders have bet on banks whose situation then deteriorated badly.  Some of these insiders just didn’t get it.  Over the years we saw evidence that a lot of directors were out of the loop or just lied to, but even officers have been betting on some of these dud banks.  The pros running real money know that officers know much more than directors do.” 
 
5.  Key Principle
 
Dave:  “One key principle that I’ve been failing to capitalize on for months now, there’s a major asymmetry in the way i-buy stocks move.  Assume a quality i-buy where the stock still won’t move because the market’s weak.  If you hold it and the market falls 1/2%, the i-buy stock will fall 1/2%.  But if the market recovers and rises 1/2%, that i-buy stock may rise 1.5-2.%.  I’ve seen this happen dozens of times.  But I routinely dump stocks when they appear to just be tracking the market. I want stocks trading free of the market, like i-buy stocks used to.  But the asymmetry stacks the deck in our favor.  Traders who would otherwise be buying up an i-buy stock sit on the sidelines because the market stinks.  But they keep watching it.  When the market turns up, they pour into the i-buy stock, pushing it way ahead of the market.”

 
Seagate Example – May 22, 09

An insider/officer at Seagate buys 150k shares, for over $1.2 million. On the surface, it looks like a great i-buy for trading — i.e., officer buying, large quantity, popular tech stock.  But there are problems which illustrate important factors to look at when deciding whether or not to take an i-buy trade.

1. For an i-buy day-trade, you want to get in as early as possible.  However, take a look at today’s chart.   Here’s what i-buy trader Dave says about it:  “Something fishy there. The filing was widely known before it hit our source.  Volume started to spike at 11:09, then big spike at 11:10. SEC time stamp is 11:11:04.  Price popped from $8.26.  I didn’t get in till $8.39.”  STX is now trading at $8.33.  Had I recommended buying before writing this post, we could have gotten in at around $8.41. The initial “pop” is over.   (Yahoo quote here.)
2. STX is a $4B stock trades over $100M a day.  So the effect of i-buy traders is going to be overrun by the effect of program trading.  What’s the cut-off for market cap? We use $1B, but it’s not absolute.

How did the stock price jump before the insider buy was filed at the SEC?  Dave explains: “most of the world gets the data from the SEC ‘front page’ of filings.  No matter how fast anyone’s program, we’re not getting that info any faster than the time stamp, or probably 60 seconds after that.  Someone’s tapping into the in-going pipeline to the SEC, accessing data before it gets processed and put on the front page.

“I’m guessing someone in IT at the SEC has changed something to create a somewhat longer delay between incoming filings and the time they appear on the front page.”  So a delay is occurring before the SEC time-stamps the filing, giving someone access to the information faster than most programs monitoring the SEC’s site. We know this because there was a big volume spike before the SEC even says it has the data.

Dave:  “I’m not sure there’s anything nefarious going on (though maybe there is).  We’ve known for years that big data users can access SEC data via an alternate channel from how the rest of us see it, but the delay is typically so small that the effect is nil.  However, sometimes the delay opens up so wide as to be unfair.  This anomaly lasts for two or three days, and happens maybe once a year.  I’m guessing they fix the problem when they receive complaints.”

Thanks Dave!