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The Difference between a Hot Day Trading Tip and Insider Trading

Day traders, who buy and sell so quickly, frequently receive hot tips. They may be participating in message boards or chat services where hot rumors can get the blood flowing on a dull day. If these hot tips are actually inside information, though, the trader can become liable.

If you knew ahead of time about big merger announcements, interest rate decisions by the Federal Reserve, or a new sugar substitute that would eliminate demand for corn syrup, you could make a lot of money in the stock market, trading options on interest rate futures or playing in the grain futures market. In doing so, however, you'd have an unfair advantage.

If everyone believed that such unfair advantages were common, then they would be unwilling to participate in the capital markets, and that would harm the economy.

Insider trading is not well defined. Any non-public information that a reasonable person would consider when deciding whether to buy or sell a security would apply, and that’s a pretty vague standard — especially because the whole purpose of research is to combine bits of immaterial information together to make investment decisions.

If you get great information from someone who is in a position to know — an officer, a director, a lawyer, an investment banker — and you act on this information in your trades or share it with someone who then acts on it, you may be looking at stiff penalties.

Civil penalties are usually three times your profits, but the government may decide that your trading was part of a criminal enterprise, making the potential penalties much greater.

Insider trading is difficult to prove, so federal regulators use other tools to punish those it suspects of making improper profits. Martha Stewart wasn’t sent to prison on insider trading charges; she was charged with obstructing justice by lying to investigators about what happened.

Whenever a big announcement is made, such as a merger, the exchanges go back and review trading for the past several days to see whether any unusual activities occurred in relevant securities and derivatives. Then they start tracing that activity back to the traders involved through the brokerage firms to see whether the activity was coincidence or part of a pattern.

By the way, most tips turn out to be groundless, or at least not as interesting to the market as it seems like they will be. Real insider information is hard to get, but starting a rumor is easy-peasy.

The bottom line is this: You may never come across inside information. But if a tip seems too good to be true, it probably is, so be careful.

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