The truth about insider trading

I wonder if SAC Capital's Steve Cohen sent Michael Lewis a thank-you note. Lately, it seems like all anyone can talk about is high-frequency trading and the new book "Flash Boys." But long before there was HFT, there was insider trading.

There's a common perception (fueled by a rabid media) that insider trading is equivalent to getting Wednesday's winning lottery numbers on Tuesday. Sometimes it is — but not often. Don't get me wrong, if Rajat Gupta called me at 3:58 p.m. to say Warren Buffett is going to infuse Goldman Sachs with a $5 billion boost in the middle of a financial crisis, that would be like LeBron James stealing the ball and heading down court for a SportsCenter highlight.

But there are countless moving parts to determine a stock price. And before you buy or sell a security, you want to know all of them. It's called the mosaic theory of investing. So just because you have an advantage on one of these moving parts doesn't mean the others will fall into place. I think a former portfolio manager from Galleon (where I was a trader during the first tech bubble) said it best when he testified in the insider-trading trial against Galleon founder Raj Rajaratnam, "The firm did its homework—but also cheated on the test."

You know what's the worst kind of inside information? The kind that loses you money. And yes, it happens. There's an old Wall Street adage: Stocks don't lie … People do.

Read MoreDuff's reaction to 'Flash Boys' and HFT: We knew someone was stealing from us!

Just like with anything, it's important to consider the source. How good is their information? Where did they get it? And, most importantly: Do they have an ulterior motive? If a guy's telling you he has inside information — stay away from him like he's wearing a wire. If he's willing to cheat for you, he's willing to cheat against you.

Here's why they get caught

I never understood why counterfeiters didn't make ones and fives. It's the smart move. Not even the feds care about bills that would insult a stripper.

Do you think anyone would have noticed that Lance Armstrong was cheating in the 50th annual Andy Griffith Tour de Mayberry? Or that Barry Bonds was juicing when he smacked 70 home runs in the Central Park Softball League? I don't think so.

Wiretaps, lying and informants are the top reasons people get busted for insider trading today.

Hans Neleman | Stone | Getty Images

The rule used to be "nothing in print." If you needed to share a secret you got on the phone, you'd suggest someone call you on the "outside," meaning your cell phone or at home at night. But wiretaps have changed the game.

The feds go after the higher profile cases, but — and this is a big but — if you're working underneath one of these people, you're the first visit they make. They like to show up right as you are getting the kids ready for school or on your lunch break. And they're always good for a catch phrase or two when introducing themselves. When the clerk asks, "How do you take your coffee," the feds standing in line might answer for you and say, "Alone. Sir, we'd like to speak with you."

Read MoreHFT isn't the problem—insider trading is: former SEC lawyer

All they need to do is pinch the younger guy and then work their way up. They get an informant like Hansel and Gretel who leave a trail of breadcrumbs that lead straight to an insider trading conviction.

Raj Rajaratnam's wiretaps were very incriminating and eventually led to his conviction.

Click here to watch the "American Greed" episode on Raj Rajaratnam. Plus, watch the all-day "Greed" marathon this Friday starting at 6 am ET.

Martha Stewart got a tip to sell ImClone (before I did — I was horrified she got a better call than me). She didn't go to jail for insider trading – it was for lying about it.

Stevie Cohen and his band of Merry Men at SAC Capital seem to be facing a more daunting task than "The Warriors," who had every gang in New York City and the authorities looking for them (a cult classic — if you haven't seen the movie, you should.) Eight employees of SAC (now known as Point72) have so far been convicted of insider trading and the firm agreed to a $1.8 billion settlement. But, despite years of investigations, wiretaps, informants and whatnot, they haven't been able to get the SAC founder on insider trading.

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Back when I used to walk to Wall Street uphill both ways in the snow, there were certain tricks of the trade you were expected to abide by if you were going to operate in the gray area:

  • Never trade options on a sure thing — it's the first place they look.
  • Always have a paper trail — an email pitching you the idea for every reason except the inside information.
  • Buy more than you want and then sell some before the announcement. It shows misperception. If you knew about the announcement then why would you sell some right before?
  • Never have inside information in print. Only use the phones (this one is changing)
  • Find the derivative stocks that will benefit from the news, play those big.
  • Be prepared for a phone call with the Securities and Exchange Commission. Play dumb, but have your story straight.
  • Discuss the trading idea with other employees, but withhold the secret sauce.
  • Reward your informant handsomely.

It's not about greed

Why take the risk? It used to feel like there were no consequences, but that has since changed. Most people love to point to greed. They think everything is based on this one deadly sin. Greed. Greed. Greed. I can't get enough greed! But they're wrong. The real root to insider trading is fear. It doesn't make it right or legal — but maybe it's easier to relate to. It's: I'm afraid of getting beat by the competition and losing my job vs. I need to redo the kitchen in my Hampton's house.

Wall Street is a bottom-line business. Either you perform — or you're out.

And here's another thing: I know insider trading isn't a victimless crime, but it's also not a crime with a ski mask and pistol. When you go into the market, you're buying or selling from someone who wants to buy or sell. There's a more-than-likely chance they'll execute their trade whether or not they are buying or selling it from a cheater. They're in the market. There's a guy waving a flag, saying, "Take my shares! Take my shares!"

With the crackdown on insider trading, my guess is that Wall Street has cleaned up a lot more than people give it credit for. Does it still go on? I'm sure at some level, but it's not rampant. I have friends who now have a general counsel at their beck and call. It's protocol to get on the phone with a lawyer immediately after hearing something that might be considered inside and discuss the legality of it.

The old trade used to be: Cut corners, play it fast and loose and reap the rewards. The new trade is: Cut corners, play it fast and loose and lose your freedom. We've all seen the perp walks. We know what's at risk. And for what — an extra $100K here or there? That's definitely not worth jail time.

Commentary by Turney Duff, a former trader at the hedge fund Galleon Group. Duff chronicled the spectacular rise and fall of his career on Wall Street in the book, "The Buy Side." He is currently working on his second book. Sony recently bought the rights to his first book to turn it into a movie or TV show. Follow him on Twitter @turneyduff.

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