Asymmetric Information – Beating the Stock Market Insiders

by Rich Hamilton

We often need to dress up simple concepts with fancy language. Asymmetric information is a case in point.

Asymmetric information means someone knows more about something than you do.

Usually, this isn’t a problem. Who cares if someone else knows how to say stock market in Latin?

You care though if someone beats you at poker because they can see your hand. And you care if you’ve just bought shares from someone who’s selling because they know the stock’s about to take a beating.

Trading on inside knowledge is a criminal offense, but it goes on all the time because it’s very hard to detect provided the perpetrators don’t get too greedy and exercise a small amount of care.

In recent years the SEC has brought insider trading cases against:

• Corporate officers, directors, and employees who traded the corporation’s securities after learning of significant, confidential corporate developments;
• Friends, business associates, family members, and other “tippees” of such officers, directors, and employees, who traded the securities after receiving such information;
• Employees of law, banking, brokerage and printing firms who were given such information to provide services to the corporation whose securities they traded;
• Government employees who learned of such information because of their employment by the government; and
• Other persons who misappropriated, and took advantage of, confidential information from their employers.

These cases are most likely the tip of an iceberg.

Too many small timers suffer because they are on the wrong side of the asymmetric information axis. They buy when the smart money’s selling and sell when the smart money’s buying.

If, like me, you don’t like games where the dice are loaded against you, what can you do to beat the crooked market insiders and company insiders?

Well, you could play their game and get some inside information and trade on it. There are two flaws with this strategy. First, you might be given false inside information. Second, you might be stupid enough to get caught and go to prison.

Better, you can ensure you only play the game if you have the same access to information as other players have. Technical analysis – my preferred method is trend following – is a fairer game to play.

When you follow a trend, whether it’s an uptrend or a downtrend, nobody has access to better information than anyone else. The price and volume information is there for everybody to see. Whether insiders are driving the price up or down, the chart reveals all.

All too often, I’ve seen the sort of situation develop shown in the chart below; read the annotations. If only the investor had watched the trend rather than listened to company announcements, his or her capital would have been saved. While insiders are often your enemies, the trend is usually your friend.