What is 'Front Running'
Front running is the unethical practice of a broker trading an equity in his personal account based on advanced knowledge of pending orders from the brokerage firm or from clients, allowing him to profit from the knowledge. It can also occur when a broker buys shares in his personal account ahead of a strong buy recommendation that the brokerage firm is going to make to its clients.
BREAKING DOWN 'Front Running'
In the context of stock trading, front running is the practice of stepping in front of orders placed or about to be placed by others to gain a price advantage. For example, a broker receives an order from a client to buy 500,000 shares of XYZ Company. He holds it until he executes the purchase of a smaller order of the same stock in his own account. He then executes the client’s larger order, which drives up the share price. The broker can then sell his share, making a profit at the direct expense of the client. That form of front running is not only unethical, it is illegal.
Index Front Running
Index funds, which have enjoyed many years of outperformance at the expense of active traders, have become their targets for another type of front running. Index funds generally try to track an index by mirroring its portfolio. Because the index changes its composition of stocks periodically, traders can anticipate when an index fund is going to update its portfolio, and step in front of the trade. For example, in 2015, American Airlines Group Inc. was added to the Standard & Poor’s 500 index (S&P 500 index). The minute the addition was announced four days earlier, HFT traders were able to start buying up shares in advance of the rest of the market and benefited from an 11% gain by the time it was actually added to the index.