(By Larry D. Spears) Insider stock transactions – the buying and selling of stock by corporate "insiders" – won't tell you where the overall stock market is headed. But the analysis of this type of legal insider trading can be a handy indicator when it comes to making buy and sell decisions on individual stocks.

In fact, by watching insider transactions, investors can actually gain an edge in certain situations, an academic researcher and leading expert on insider transactions said in an interview with Barron's earlier this month.

"What we found is that in small companies, insider trading is more predictive. When insiders trade more, those transactions are more predictive," said the researcher, H. Nejat Seyhun, a professor of business administration and finance at the University of Michigan's Ross School of Business. "And large trades by top executives tend to be more predictive. Maybe in smaller firms, it is easy for top executives to understand everything about the company. There is also a lot of volatility in smaller firms, so whatever information they have has large return implications. They take advantage of this by trading."

If your primary source of information is the sensation-driven popular media, you probably have at least three distinct impressions about insider stock trading:

• It usually involves unscrupulous executives or their shady financial associates reaping large and illicit profits by buying shares in a company based on information the general public isn't yet privy to – information that will send the stock price soaring once it's announced.
• It's nearly always illegal.
• It's always unfair to the average investor.

The reality is that all three of those impressions – while they may reflect today's headlines – are largely incorrect. Insider transactions by beneficial owners, board members, executives, managers and the like – occur on a daily basis, with most transactions based on public information or personal financial considerations. And it's perfectly legal, so long as trades above a certain size or value are reported to the U.S. Securities and Exchange Commission (SEC). Section 403(a) of the Sarbanes-Oxley Act of 2002 requires the reporting of insider stock trades within two business days, and the SEC issues an updated list of these filings each Friday. Companies must also file a so-called "Form 4" report by the 10th day of each month listing all insider trades for the prior month.

What's more, it can actually be highly advantageous to average investors who monitor insider trades as a guide to what's going on with specific companies, industry groups or the market as a whole. Indeed, there's a standalone industry of advisory services that base the bulk of their recommendations on the actions of corporate insiders, as reported to the SEC.
The general premise underlying the analysis of legal insider trading is fairly basic:

• When a lot of corporate insiders are buying shares in their company, it typically means they see improving business conditions ahead. Thus, it's a bullish indictor for the individual stock – and possibly for the industry the company is in.
• When a large number of corporate insiders are selling shares in their company, it usually indicates that rough times are ahead. Thus, it's a bearish indicator for the individual stock – and maybe for its industry.
• When insiders for a large number of different companies are buying stock, it's bullish for the market as a whole – and, when a lot of insiders at different companies are selling, it's bearish for the overall market. Because of this, the "ratio of insider buys to insider sells" is a closely watched indicator for many analysts and market advisors.

The Lowdown on Insider Buying

However, as is usually the case with broad theories, the actual analysis of insider trading isn't quite that simple. For starters, most analysts place far more emphasis on insider buying than they do on insider selling.