In this paper, we examine the profitability of insider trading in firms whose securities trade in the OTC/NASDAQ market. Although the evidence suggests timing and forecasting ability on the part of insiders, high transaction costs (especially bid-ask spreads) appear to eliminate the potential for positive abnormal returns from active trading. By implication, outside investors who mimic the trading of insiders are also precluded from earning abnormal profits. In addition, we provide evidence on the determinants of insiders' profits. The data suggest that insiders closer to the firm trade on more valuable information than insiders removed from the firm. STUDIES OF INSIDER TRADING generally find that insiders make positive abnormal trading profits.1 Perhaps more importantly, many of these studies also show that "outsiders" can earn profits by mimicking the trading of insiders after the public release of information about insider transactions. This finding, which suggests semi-strong form market inefficiency, has been reexamined. Seyhun (1986), evaluating approximately 60,000 insider transactions in New York Stock Exchange (NYSE) and American Stock Exchange (ASE) companies between 1975 and 1981, concludes that insiders make abnormal profits but that these profits are not especially large. He also finds that outside investors cannot make abnormal returns, net of transaction costs. Rozeff and Zaman (1988), using data on insider trades in NYSE firms from 1973 to 1982, reach similar conclusions.The purpose of this paper is to examine the profitability of insider and outsider trading using data from the OTC/NASDAQ market. We also provide evidence on the determinants of insider trading profits. This study is of interest for several reasons. First, the market microstructure of the OTC market is different from that of the organized exchanges. The multiplicity of market makers in the OTC market may allow insiders to more carefully conceal their trading. Second, the degree and effectiveness of regulatory scrutiny may differ across markets. Third, transaction costs, particularly the bid-ask spread, are higher for OTC firms. We explicitly examine bid-ask spreads in our analysis of insider and outsider profits.Finally, the relatively small size of firms in the OTC market has two important implications. Because of the presence of the "size effect" (Banz (1981)), careful attention must be given to the empirical methods. Further, smaller firms may be * Both authors are from the Department of Finance, Louisiana State University. We would like to thank K. C. Chen, Maurice Joy, Gary Sanger, participants of the LSU Finance Workshop, and, especially, the co-editor, David Mayers, and an anonymous referee for helpful comments. Remaining errors are our responsibility. 'See, for example, Lorie and Niederhoffer (1968), Pratt and DeVere (1968), Jaffe (1974a,b) and Finnerty (1976a,b). Insiders are defined as officers, directors, and owners of ten percent or more of any equity class of securities.
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