Front running is the illegal practice of purchasing a security based on advance non-public information regarding an expected large transaction that will affect the price of a security. Front running is considered as a form of market manipulation and insider trading because a person who commits a front running activity expects security’s price movements based on the non-public information. However, some forms of the front running, such as index front running, are not illegal.
Examples of Front Running
#1 Anticipating large future transactions
Front running is usually committed by brokers or brokerage firms and is considered the most common kind of front running. A broker receives an order from a client to purchase 100,000 shares in Company A. The broker knows that the large buy transaction is likely to drive up the price of the company’s stock. Thus, he decides to purchase for himself 2,000 shares in Company A before executing the client’s order.
He buys 2,000 shares at $10 per share and then executes the client’s order. Immediately after the execution of the client’s order, the stock price jumps to $13 per share. Then, the broker sells his 2,000 shares at $13 per share, earning a profit of $6,000. In such a scenario, the broker commits unethical and illegal activity by breaching his fiduciary duty to his client.
#2 Anticipating news affecting the price of a security
An individual possessing non-public knowledge of an upcoming event that will affect the price of a security can execute a trade before the information is provided to the public. For example, an analyst prepares an investment recommendation report about Tesla Inc. The report is still to be distributed to the clients, and the analyst knows that the report states a strong BUY recommendation.
Anticipating that after the publication of the report, many investors will buy Tesla’s stock and the stock’s price will increase, the analyst decides to buy the company’s stock before the report becomes available to the public. Thus, the analyst will make a profit after the stock price increases.
#3 Index front running
Index front running is not illegal and is utilized as a trading strategy. Index funds, which shadow the market indices, are becoming extremely significant in financial markets. Whenever a new stock is added to a market index (e.g., S&P 500), the announcement is made before the stock is actually added.
For example, S&P 500 announces that Hi-Tech Inc. will be added to the index in the next day. The next day, high-frequency traders may quickly purchase the company’s shares before the index funds are able to buy the company’s stock. The index funds will push the stock price up because of the large volume of their orders. Therefore, the high-frequency traders profit from the front running the index funds.
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