Stock trading is in a large part, a game of signals. Depending on what strategy you are using, either algorithms, black boxes, fundamental analysis or technical analysis of charting, most traders trade based on signals generated by whatever trading or stock-picking system they use. While signals can be picked from different sources and used from a combination of systems or strategies, one area that can signal a buy or sell is directors’ share dealings.
Asymmetric information arises when one party to an economic transaction has more material knowledge in a transaction than another. This is one of the agency problems in corporate governance. It happens in companies because the directors know and have more knowledge about the financial health of a company than the shareholders.
Because of that privileged “advanced” knowledge that company directors have about the health and well being of the companies they oversee, investors should take notice of and interest in the buying and selling of company shares by the directors, as such activities can be loaded with profitable entry or exit signals
Insider dealing is a stock trading crime and as such, insiders such like directors send notifications to the regulatory authorities about their intension to buy and sell shares of their companies or the actual transactions. More often than not, the authorities, like the Nigeria Stock Exchange, publish such notifications to keep the public in the loop. The Nigerian Stock Exchange, in particular, publishes “notification of share dealing by insider”. By typing that into the search window on their website, you arrive at a list of such events. There have been about 74 insider share dealing notifications on the Exchange’s website since January 1, 2020.
It is through those publications that one can gain knowledge of and the thinking of insiders about the direction of a company. For example, in one of the latest of such publications, on May 21, 2020, to be precise, the managing director and CEO of AIICO Insurance, Babatunde Fajemirokun, notified the exchange that he bought 3,769,586 shares of AIICO insurance on May 20th, 2020, at a price of N0.96. The question that readily comes to mind is why would an MD buy the shares of his company? The common-sense answer, among others, is because he wants to make money from such purchases, and the only way, he can make money is if the share increases in price after the purchases. Therefore, the fact that the managing director, an insider, bought the shares, is an indication that he thinks, based on all the facts that he has or knows about the company, that the shares of the company are bound for an increase in the near future. True to that thinking, the shares of AIICO closed the week at a price of N1.01, giving the MD an unrealized gain of N0.05 per share or N188,479.3 on that transaction, alone. The signaling impact, in this case, is even more glaring when one takes note of the fact that a few days earlier, on May 18th, 2020, the same managing director of AIICO Insurance bought 1,198,330 shares of AIICO at N0.90 per share. In fact, from May 15th through May 20th, the MD bought over 6 million shares of AIICO Insurance. The above case study underscores how following or paying attention to insider share dealings can be used as a trading strategy or one of the ways to discover a stock trading signal.
It is not only in Nigeria that things of this sort happen, it happens all over the world and it has been happening over a long time, so much such that it had elicited and continues to elicit research interest among academics and analysts. A research conducted by Jaffe (1974) and Finnerty (1976) indicated that using director dealings as a trading signal produced abnormal returns in the months following. This finding has been agreed to by other researchers like Givoly and Palman (1985), and Jeng, Metric, and Zeckhauser (2002), although Grivoly and Palman attributed part of the added return to price increases due to investors mimicking directors. There are other researches, though, that found out that using directors’ dealings as signals may not yield the required results due to trading costs.
In a not too efficient market, like that of Nigeria, insider or directors share dealings can provide a profitable trading signal, but such signals may not last forever. Therefore, time is of the essence for those who want to explore such trading strategies. The earlier you discover such signals and act on them, the better you will be positioned to derive the benefits that may accrue from them.
There’s a caveat
Note that this presentation is not and should not be construed as investment advice. Anyone who uses the strategy does so at his/her own risk with no liability of any sort from the author and publisher.