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Signaling

The act of using insider information to initiate a trading position

What is Signaling?

Signaling refers to the act of using insider information to initiate a trading position. It occurs when an insider releases crucial information about a company that triggers the buying or selling of its stock by people who do not ordinarily possess insider information. The actions of the insider are considered a market signal to outsiders.

 

Signaling

 

Market signaling may be obtained by tracking the shareholding and trading positions of a company’s insiders. Insiders are usually senior executives or other large shareholders of the company. They may possess decision-making powers and be able to access internal information about the company.

 

What is Insider Information?

Insider information is a non-public fact that gives traders an advantage when trading the company’s stock. Insider information is usually obtained by a person who is an employee or executive of the company. An “insider” may also be an outsider who is closely associated with the company.

When such persons gain knowledge about company developments that can affect its stock price, that information provides an unfair advantage over outsiders, unless the information is made public.

Insider trading is considered illegal. Insider trading exists when an officer, employee, or director of the company uses material, non-public information about the company to place trades or advise third parties to initiate trades. This is viewed as an unfair manipulation of the free market.

 

How to Interpret Insider Information Signaling

Using insider trading activity for market signals is one of the strategies investors use in trading stocks. This is because insiders have a broader knowledge of the company, which can provide helpful insights into the value of the company’s stock.

For example, when an insider sells a large quantity of company stock, this can be a negative indicator for the stock’s future price movement. Outside investors can read this signal and follow suit by disposing of their own shareholdings.

Conversely, when a senior executive buys the company’s stock in large volumes, he or she may be doing that based on knowledge only held by a few people within the company. Such behavior signals that the company expects positive future growth or improvement in its financials. Investors can follow the lead given by the executive and buy the company’s stock.

 

Dividend Signaling Theory

The dividend signaling theory states that when a company announces an increase in its dividend payout, financial analysts and investors read that as indicating a positive future financial outlook for the business. While many analysts are skeptical about the dividend signaling theory, there is some evidence for its validity.

Generally, increases in dividend payouts paint a positive outlook for the company’s financials and future stock price. A decrease in dividend payouts may indicate expected hardships for the company’s financials. The dividend signaling theory basically suggests that companies that pay the highest dividends will be more profitable. However, some studies have concluded that dividend payouts are not necessarily related to earnings.

With most large companies, increases in dividend payouts are approved by the board of directors if they are satisfied that the company anticipates making profits in the future and that the cost is manageable. Examples of companies that have increased their dividend payouts consistently include FedEx Corporation, Nordson Corporation,  and Procter and Gamble. Companies that have increased their dividend payout for at least 25 years straight are known as “dividend aristocrats”.

 

Technical Analysis of Candlestick Signals

In technical analysis, trading is based on identifying and interpreting the market signals provided by various technical indicators. For example, the price of a security may be analyzed using candlestick patterns to predict future price movement.

Bullish and bearish trend movements send different signals to traders. The pattern of a candlestick produces market signals that indicate whether to enter a long or short position in the market.

 

Related Readings

We hope you’ve enjoyed reading CFI’s discussion of signaling. CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Earnings Guidance
  • Sarbanes Oxley Act
  • Technical Analysis – A Beginner’s Guide
  • Types of SEC Filings

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