[maxwell_smart]

Wow. I remember that back in the day, it was commonly argued that derivatives trading would reduce volatility in the markets. This is no different. Under certain assumptions, insider trading would lead to a more efficient market, and under others, a far less efficient market.

Quick question: which of these scenarios do you think captures the mentality of an inside trader?

A: I NEVER hold shares in companies that I do not fully believe in, and I ALWAYS take a long position. If I get inside information that a company is in trouble, I will immediately liquidate my position-- it may not blow up on me today, or tomorrow, or even this year, but I trust that sooner or later the stock price will take a dive, and I want to be long gone when that happens.

B: I have inside information that a company is in trouble. I don't know when it will blow up, but I do know that I have an edge on everybody else who doesn't know what I know. So, I should ride the stock all the way up, as long as it keeps going up, and short it on the first sign of trouble on the technical indicators. This way, I can make my money on both ends-- the up and the down.

One of these strategies will act to reduce volatility, and the other will enhance it.

[codeslinger]

The problem with your assessment is that it proves Don's point in the article. The B trader will reveal his inside information much more rapidly than if he were not able to act on it, thus increasing the amount of information available to the market as a whole, enabling better decisions by others regarding the security in question.

I agree, the "B" traders are more likely, but that's a good thing.

[maxwell_smart]

I don't follow you at all. If the information available to the market is provided at the point the insider executes the "sell" then it is the B trader who provides his information later, and all the B traders will tend to act nearly at once.

In the A scenario, the A traders sell immediately, and act upon receipt of the inside information, rather than react to each other, so the information is furnished to the market gradually by all A traders.

Please tell me in more detail what you think of the scenario that I posed, and how it makes the point of the article.

[btilly]

More problematic are the "C" traders. People with access to inside information who therefore believe that they'll get news of things that will shift prices before anyone else. These people are then able to take risks and time more aggressively, trusting that they'll be able to jump ship at need. These people therefore avoid revealing inside information until the last possible moment.

But the real trouble is the "D" traders. People with no access to inside information who have no interest in providing excess rents to traders A, B or C. When this group of people gets the impressions that the real gains in stocks go to insiders, and outsiders get the shaft, they stay away in droves. In fact the desire to encourage this group to invest is one of the primary reasons for the insider trading laws in the first place.