Front Running Explained

By Samuel Becker · August 06, 2021 · 6 minute read

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Front Running Explained

Who wouldn’t want to be a frontrunner? In most instances, hearing the term “front running” may make you think that you’re doing something right. But when it comes to front running and trading? It’s a bit of a different situation.

That’s because front running, as it relates to trading and investing, involves insider information, and possibly illegal transactions. For that reason, it’s important for traders or investors of all stripes—from newbies to veterans—to be familiar with what front running means, what front running means to the Securities and Exchange Commission (SEC), and why you may want to avoid it as a part of your investing strategy.

What Is Front Running?

In short, front running trading means that an investor buys or sells a security (a stock, bond, etc.) based on advance, non-public knowledge or information that they believe will affect its stock price. That information is not yet public, giving the trader or investor an advantage over other traders, and the market at large.

But it’s easy to see how front running earned its moniker, too. Traders, making moves based on inside or non-public knowledge, are getting out ahead of a price movement—they’re running out in front of that movement, in a very literal sense.

This may sound familiar, or cause another term to spring to mind: Insider trading. In fact, front running is a form of insider trading and market manipulation (you don’t want to break the rules and have to deal with the fallout!)

Recommended: Everything You Need to Know About Insider Trading

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. It can not only involve stocks, but also derivatives, such as options or futures.

Front running is illegal, and forbidden by the SEC. It also runs afoul of the rules set forth by regulatory groups like the Financial Industry Regulatory Authority (FINRA). Of course, this doesn’t mean that individual traders or portfolio managers don’t take part in a little front running here and there, but generally speaking, it’s a practice that’s frowned upon in the financial industry.

A Front Running Example

Let’s run through a hypothetical example of how a common form of front running may work.

Say there’s a day trader, Theo, working for a brokerage firm, and they manage a number of client’s portfolios. One of Theo’s bigger clients calls up and asks them to place an order: The client wants to sell 200,000 shares of Firm X. Theo knows that this is a big order—big enough to affect Firm X’s stock price on the markets.

With the knowledge that a big order is soon to go through and cause Firm X’s stock price to fall, Theo takes a look at his own personal portfolio, sees that he owns some Firm X shares, and decides to sell them, anticipating the fall in value.

Theo makes the sale, then executes the client’s order (blurring the lines of the traditional payment for order flow). Then, Firm X’s stock price falls, and Theo saves himself some money, which he may use to invest in other stocks, or buy Firm X shares at a now-discounted price, and potentially, ultimately increasing his profits.

Theo would’ve broken the law in this scenario, breached his fiduciary duties to his client, and also acted unethically. While people do get caught front running in the real world, and it’s actually a fairly common practice in some stratums of the financial world.

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. Back in 2009, for instance, 14 Wall Street firms were hit with roughly $70 million in fines by the SEC for frontrunning.

“The SEC charged the specialist firms for violating their fundamental obligation to serve public customer orders over their own proprietary interests by ‘trading ahead’ of customer orders, or ‘interpositioning’ the firms’ proprietary accounts between customer orders,” an SEC release reads.

Further, research into the topic of front running finds that when people (or firms) have insider knowledge that could benefit them in the markets, they’re likely to use it.

As for another real-world example of front running, there was a case in 2011 involving a large global bank, and some foreign exchange traders who found themselves in hot water. The two traders became privy to a pending order from a client, made some moves to get ahead of it—front running!—and ended up making their company money .

There was big money involved, too. It was a $3.5 billion transaction, and by front running the trade, the traders were able to make more than $7 million. It’s not a happy ending, however, the people involved ended up sentenced to prison and ordered to pay hundreds of thousands of dollars in fines.

So, while front running does happen, there can be serious consequences if regulators catch wind of it.

Are There Times When Front Running is Okay?

Yes, actually. Index front running is not illegal, and is actually fairly common among active investors.

As many investors are aware, index funds track financial indexes, like the S&P 500 or Dow Jones Industrial Average. They’re funds designed to mirror the performance of an index, in other words. And since market indexes are really nothing more than big amalgamations of stocks, they change quite often. Companies are constantly swapped in and out of the S&P 500, for instance.

When that happens, it’s generally announced to the market, and 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 it’s likely Firm X’s stock price will 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.

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 probably not something that the average trader or investor is going to need to worry about. After all, how often do you find yourself face-to-face with confidential information that could move the markets? Probably not often. But it’s still helpful to know the frontrunner definition.

If you’re not necessarily looking to front-run any trades, but simply start putting your money in the market, the SoFi Invest® brokerage platform can help you do it. You can open an account with as little as $5 and use it to invest in stocks, exchange-traded funds, and cryptocurrency.

Photo credit: iStock/Drazen_

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