Throughout the month of September we will hear about the work being done by the members of the Centre for Governance, Regulation and Industrial Strategy. Here Hanwen Sun presents the findings of her recent research, which explores how corporate insiders strategically trade their shares in response to the presence of short sellers.
My recent paper set out to explore how corporate insiders alter their trading strategies when seeing short sellers actively exploit trading opportunities from insider sales.
By corporate insiders, we generally refer to the officers, directors or substantial shareholders of a company. Corporate insiders are legally permitted to buy and sell shares of the firm and any subsidiaries that employ them once their transactions are not utilizing non-public material information. However, a class of information events that is especially difficult to decipher is the trading activity of corporate insiders. It is widely recognized that these people have superior ‘information advantage’ compared to other stakeholders and their trades generally incur abnormal returns and profits. However, they now face unprecedented challenges in their monopoly of private information, given the fierce competition from the surge of sophisticated investors like short sellers.
One reason for this is that the trades placed by insiders generate ‘order flows’ into the financial market. In simple terms an order flow is the number of orders (or trades) that are waiting to be executed at a certain price level. This affects the price of the stock because if there are more buyers than sellers the price goes up, and if there are more sellers than buyers the price goes down. If you are watching the order flow, you can predict future price movements. Sophisticated investors who employ an ‘order flow trading strategy’ serve as competition for the insiders, as it piggybacks on the insiders’ information advantage. Short selling is a key part of this trading strategy – if an investor bets that a stock is going to go down then they can borrow it and sell it on the open market, and then buy it back later for less money. Indeed, a growing strand of literature documents that short sellers learn from insiders’ order flows and trade accordingly for profit. These challenges force insiders to develop more strategic and dynamic trading approaches to stay profitable.
Understanding the interactions between insiders and short sellers
We developed a model looking at the relationship between the trading strategies of corporate insiders and short sellers, to understand how the former responds to the latter’s activities.
Our model predicts that insiders tend to adopt a cautious trading strategy (aka splitting their trades over time and reducing initial sales) when they see that short sellers are using order flows to predict trading patterns, in order to disguise their order flows and prevent these tactics.
Empirically, we identified cautious trading by tracking consecutive transactions at the insider-strategy level. We find that, when anticipating intensive short selling potential:
- insiders tend to trade cautiously; and
- cautious insiders tend to reduce their initial trades.
Identifying insider trading patterns
Our findings have important implications. First, for investors, our paper suggests that consecutive insider trading may reflect insiders’ private information not yet revealed in price. Therefore, it may be more profitable to trade alongside cautious insiders than aggressive insiders.
Second, for regulators, our results reinforce the increasing concern that insiders manage trade sizes and timing according to the nature of information. This represents a regulatory challenge, and our results suggest that regulators need to take insiders’ cautious trading strategies into consideration when identifying illegal insider trading.
Finally, from the perspective of information dissemination, our results suggest that, although the presence of short sellers may accelerate the rate at which private information is revealed to the market via insider trading, insiders can still manipulate their trading patterns to delay price discovery.
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