Front Running

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. However, there are other forms of front running that, while appearing to be unethical, are still legal.

Legal Front Running

Front running is only considered illegal if a broker or trader uses information to his advantage that is not available to the public. The age of high-frequency trading (HFT) has introduced a new form of front running that, on its face, is not illegal because it utilizes information widely available to the public. The problem is, HFT traders using powerful computers are able to detect the information within milliseconds of its dissemination, enabling them to capitalize on it almost instantly. Specifically, their computers are able to detect orders that are about to be placed by other traders, allowing them to jump in front of the trade, which then drives up the share price. The other trader’s order is then executed at a higher price, providing the front running trader a profit. The whole process is automated by computer programs and can take place within one to 10 milliseconds.

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-percent gain by the time it was actually added to the index.

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