Front-running is trading stock or any other financial asset by a broker who has inside knowledge of a future transaction that is about to affect its price substantially. A broker may also front-run based on insider knowledge that their firm is about to issue a buy or sell recommendation to clients that will almost certainly affect the price of an asset.
This exploitation of information that is not yet public is illegal and unethical in almost all cases. Front-running is also called tailgating.
How Front-Running Works
Here's a straightforward example of front-running: Say a broker gets an order from a major client to buy 500,000 shares of XYZ Co. Such a huge purchase is bound to drive up the price of the stock immediately, at least in the short-term. The broker sets aside the request for a minute and first buys some XYZ stock for their own personal portfolio. Then the client's order is put through. The broker immediately sells the XYZ shares and pockets a profit.
- Front-running is illegal and unethical when a trader acts on inside information.
- A straightforward example of front-running occurs when a broker exploits market-moving knowledge that has not yet been made public.
- There are gray areas. An investor may buy or sell a stock and then publicize the reasoning behind it. Transparency and honesty are key.
This form of front-running is illegal and unethical. The broker has made a profit based on information that was not public knowledge. The delay in execution may even have cost the client money.
Front-running is similar to insider trading, with the minor difference in this case that the broker works for the client's brokerage rather than inside the client's business.
Exploiting Analyst Recommendations
Another tactic for front-running is acting upon an analyst recommendation that has not yet been published.
The analysts work in a separate division from the broker and concentrate on evaluating the potential of individual companies in order to advise the company's clients. They constantly issue "buy," "sell," or "hold" recommendations for specific stocks. These go directly to clients first and then are picked up by the financial media and reported widely.
A broker who acts upon that recommendation for personal gain before it reaches the company's clients is front-running.
There is some grey area here. For example, a professional short-seller may accumulate a short position and then publicize the reasons for shorting the stock. This seems perilously close to a short-seller's version of a pump-and-dump scheme, in which a speculator hypes (or bashes) an investment for personal gain.
There is a distinction, however. The short-seller in this example reveals the personal financial stake at the time of the recommendation. And, the information conveyed by the short-seller reflects a genuine fact-based view of the outlook of the stock shorted rather than a falsehood intended to mislead.
A form of front-running in index funds is common and is not illegal.
Index funds track a financial index by mirroring the index's portfolio. The composition of the index changes periodically in order to balance it accurately as the stocks that make it up change dramatically in price or as stocks are added or removed from the index. That forces the fund's managers to buy or sell some components of the index.
Traders watch the prices of those stocks, and they know when an index fund will update its components. They will front-run the trade by buying or selling shares to gain an edge.
This is not illegal because that information is available to all those who are paying attention.
Example of Index Front-Running
The Standard & Poor’s 500 Index (S&P 500) added American Airlines Group Inc. to its holdings in 2015. Immediately after the announcement, traders also bought shares because they knew that all of the indexes and funds that track the S&P 500 would be buying shares, forcing its price up.
American Airlines stock increased by 11% by the time it was officially listed in the index.