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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 and selling of its stocks by people who do not possess insider information. The actions of the insider are considered a market signal by outsiders since people inside the company are known to possess insights into its performance and business dealings.

 

Signaling

 

Market signaling may also be obtained by tracking the shareholding and trading positions of a company’s insiders. The insiders are usually senior executives or large shareholders who own substantial stocks of the company or possess decision-making powers, and therefore, can access internal information about the company.

 

Technical Analysis of Candlestick Signals

In technical analysis, trading is usually based on reading the market signals of various types of security to determine when to enter or exit the market. For example, the price movements of a security may be tracked using candlestick patterns, which move in different directions depending on the trend.

As such, bullish and bearish trends movement in opposite directions, and they send different signals to the traders. The shape of the candlestick produces market signals that determine whether to enter a long or short position in order to make a profit.

 

What is Insider Information?

Insider information is a non-public fact about a company that traders can use to gain a financial advantage when trading the securities of that company. Insider information is usually obtained by a person who is an employee or executive of the company or an outsider who is closely associated with the company.

When such persons gain knowledge about the company’s major corporate developments that can affect its stock price, such information provides an unfair advantage to outsiders of the company, unless the information is made public.

Insider trading is considered illegal if an officer, employee, or director of the company uses non-public information about the company to place trades or advise third parties to initiate trades. It is because it is viewed as an unfair manipulation of the free market that is aimed to benefit a few select persons.

 

How to Interpret Insider Information Signaling?

Using insider information to obtain market signals is one of the strategies that investors use to decide when to buy or sell stocks. It is because insiders have a broader knowledge of the company, which can provide useful insights into the trends of the company’s stock price. Their knowledge of the company makes it beneficial for potential investors.

For example, when an insider with a substantial capital investment in the company sells stocks in large volumes, it can be a negative indicator of the direction that the stock price might take in future. Outside investors can read this action as a negative signal, and follow suit by disposing of their shareholding.

Insider information such as the buying and selling of stocks in large volumes can be used to indicate that certain insider information is yet to be reflected in the stock price. For example, when a senior executive buys stocks in large volumes at once, he or she may be doing that for a reason that is not yet known to the public, but to only a few people within the company.

Such behavior gives a signal that the company expects some positive growth in its financials and stock price in the future. Investors can read the senior executive’s behavior as a signal that they should follow the lead given by the executive and buy stocks of the company for speculation purposes.

 

What is Dividend Signaling Theory?

The dividend signaling theory states that when a company announces an increment in its dividend payouts, financial analysts and outside investors read that as an indicator of a positive future financial outlook for the business. While most analysts are skeptical about the dividend signaling theory, there is evidence that the phenomenon does occur.

Generally, increases in dividend payouts paint a positive outlook for the company’s financials and stock price, while a decrease in dividend payouts may paint expected hardships in the company financials. The dividend signaling theory attempts to suggest that companies that pay the highest dividends should be more profitable than companies with the lowest dividends. However, various studies contest this position, with some studies concluding that dividend payouts are not related to earnings, while other studies reaffirm the theory position.

In the real world, companies with a history of increasing the dividend payouts also posted significant financial earnings in the past. In most large companies, increases in dividend payouts are announced 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 increased their dividend payouts consistently include the FedEx Corporation, Nordson Corporation, Procter and Gamble, the National Fuel Gas, etc.

 

Related Readings

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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