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 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 front running is commonly confused with insider trading but they are distinct insider trading refers to a company insider who trades on advanced knowledge of corporate activities for example using their insider knowledge to buy or sell shares ahead of a major announcement 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 most types of front running are prohibited by sec rule 17 j 1 which sets out the ethical requirements for portfolio managers and brokers this rule has been interpreted to prohibit these insiders from taking advantage of their knowledge of client trades for personal gain 1a 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 front runningin 2020 the financial industry regulatory authority finra announced penalties against citadel securities arguing that the chicago based market maker had front run against its own clients between 2012 and 2014 according to the financial regulator citadel removed hundreds of thousands of large otc orders from its automatic trading processes requiring those trades to be executed manually by human traders at the same time citadel traded for its own account on the same side of the market at prices that would have satisfied the orders violating their obligations to their clients 2in a single sample month finra found that citadel had traded against their customers in nearly three quarters of the inactive orders citadel ultimately agreed to make their clients whole in addition to a 700 000 fine without admitting any wrongdoing 2