Table of Contents
Front running is when a broker or other investor obtains information that will impact a stock, and places a trade in advance of the news.
In most cases front running is illegal because the broker is acting on information that’s not available to the public markets, and using it for their own gain.
Front running is somewhat different from insider trading, where an individual investor working at a company is able to place a trade based on proprietary information about that company. Insider trading is also illegal.
There is another definition of front running, however, which involves index funds. This type of front running is not illegal.
Key Points
• Front running involves trading a financial asset based on non-public information in order to profit, which is illegal due to unfair market advantage.
• This practice is different from insider trading, although both involve using non-public information for personal profit, and both are prohibited by regulatory agencies.
• Front running can occur when investors or brokers use this news to anticipate significant trades, allowing them to act before the information is public.
• Real-world cases of front running have led to significant penalties, including multi-million dollar fines and prison sentences for those involved in fraudulent trades.
• While most forms of front running are illegal, index front running, which involves changes to market indexes, is considered legal and commonly practiced.
What Is Front Running?
Front running trading means that an investor buys or sells a security based on advance, non-public knowledge or information that they believe will affect its stock price. Because the information is not widely available, it gives the trader or investor an advantage over other traders and the market at large.
Based on this definition of front running, it’s easy to see how the practice — though illegal — earned its moniker. Investors trading stocks based on privately held information, are literally getting out in front of a price movement.
In addition to stocks, front running may also involve certain derivatives contracts, such as options or futures.
Again, although front running is technically different from insider trading, the two are quite similar in practice, and both are illegal. Front running is forbidden by the Securities and Exchange Commission (SEC). It also runs afoul of the rules set forth by regulatory groups like the Financial Industry Regulatory Authority (FINRA).
If a trader has inside knowledge about a particular stock, and makes trades or changes their position based on that knowledge in order to profit based on their expectations derived from that knowledge, that’s generally considered a way of cheating the markets.
Recommended: Everything You Need to Know About Insider Trading
How Front Running Works
The definition of front running is pretty straightforward, and there are two main ways front running — also called tailgating — can occur.
• A broker or trader investing online or through a traditional brokerage gets wind of a large upcoming trade from one of their institutional clients, and the size of the trade is sure to influence the price.
• A broker or trader learns about a specific analyst report about a given security that’s likely going to impact the price.
In either case, the trader gains access to price-relevant information that’s not yet available to the public markets, and they are well aware that the upcoming trade will substantially impact the price of the asset. So before they place the trade, they might either buy, sell, or short the asset — depending on the nature of the information at hand — and make a profit as a result.
A Front Running Example
Say there’s a day trader working for a brokerage firm, and they manage a number of clients’ portfolios. One of the broker’s clients calls up and asks them to sell 200,000 shares of Company A. The broker knows that this is a big order — big enough to affect Company A’s stock price immediately.
With the knowledge that the upcoming trade will likely cause the stock price to fall, the broker decides to sell some of his own shares of Company A before he places his client’s trade.
The broker makes the sale, then executes the client’s order (blurring the lines of the traditional payment for order flow). Company A’s stock price falls — and the broker has essentially avoided taking a loss in his own portfolio.
He may use the profit to invest in other assets, or buy the newly discounted shares of Company A, potentially increasing his long-term profits essentially by averaging down stocks.
The trader would’ve broken the law in this scenario, breached his fiduciary duties to his client, and also acted unethically.
Recommended: Understanding the Risks of Day Trading
Front Running in the Real World
There are many real-world examples of front running that have led to securities fraud, wire fraud, or other charges.
In 2022, for example, the SEC charged an employee of a large financial institution and an outside associate, of executing a multi-year scheme worth some $47 million in fraudulent front-running profits.
In this case, the employee took advantage of proprietary information about upcoming company trades, which he conveyed to an accomplice outside the firm. Based on the ill-gotten information, this outside trader opened and closed positions ahead of the bigger company trades, and shared the profits.
The company employee was sentenced to 70 months in prison, three years of supervised release, and both traders had to forfeit some $38 million.
Is Front Running Legal?
No. In almost all cases, front running is illegal. Front running is a type of fraud that involves using information that’s not available to the public solely for personal gain.
Are There Times When Front Running Is OK?
Yes, actually. Index front running is not illegal, and is actually fairly common among active investors.
As many investors are aware, index funds track market indexes like the S&P 500 or Dow Jones Industrial Average. These funds are designed to mirror the performance of a market index. And since equity market indexes are essentially large portfolio stocks, they change quite often. Companies are frequently swapped in and out of the S&P 500 index, for instance.
When that happens, the change in an index’s constituents is generally announced to the public, before the swap actually takes place. If a company is being added to the S&P 500, that’s probably considered good news, and can make investors feel more confident in that company’s potential.
Conversely, if a company is being dropped from an index, it may be a sign that things aren’t going so well.
That gives some traders an opening to take advantageous positions. Let’s say that an announcement is made that Firm X is being added to the Dow Jones Industrial Average, taking the place of another company. That’s big news for Firm X, and means that Firm X’s stock price could go up.
Traders, if they have the right tools, may be able to quickly buy up Firm X shares the next day, and potentially, make a profit if things shake out as expected (although there’s no guarantee they will).
How is this different from regular front running? Because the information was available to the public — there was no secret, insider knowledge that helped traders gain an edge.
The Takeaway
Front-running is the illegal practice of taking non-public information that is likely to impact the price of a certain asset, then placing a trade ahead of that information becoming public in order to profit. Front running is similar to insider trading, although the latter generally involves an individual investor who profits from internal company information.
Fortunately, there are plenty of investing opportunities that don’t involve resorting to fraudulent activity like front running.
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FAQ
Why is front-running illegal?
Front running is illegal for a few reasons. First, it’s a form of cheating the market, by using non-public information for personal gain. Second, in the case of institutional front running, it’s a violation of a broker’s fiduciary duty to a client.
How can I identify if my trades have been affected by front running?
Unfortunately, owing to the non-public nature of the information that typically leads to front-running, it’s very difficult for individual investors to determine whether or not their own trades have been impacted by a front-running event. Financial institutions have more tools at their disposal to detect incidents of front running.
Are there any technological solutions or tools available to detect and prevent front running?
Yes. With so many traders using remote terminals to place trades since the pandemic, trade surveillance technology and trade reconstruction tools are more important than ever. Fortunately, financial institutions have the resources to employ these tools, and other types of algorithms, to monitor the timing of different trades in order to identify front runners and front running.
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