Front Running Definition
Front Running, referred to as tailgating, is a prohibited wherein a broker trades the security using his pre-existing knowledge of non public information regarding a large transaction that has can potentially change the price of assets, equity or derivative with the motive of gaining economic advantage.
How Does it Work?
With the motive of gaining an economic advantage, when a broker or trader makes trade before large non publicized order, such practice is front running. For example, when a broker gets an order from a client to buy one million shares of Syndicate company and the broker ahead of executing the client’s request, places an order for the same stock for his own account and then places the client’s order, which makes the stock price to rise sharply due to the clients bulk order which creates a huge instant profit for the broker. It is an illegal trade practice that provides unfair gains to a broker or trader.
Examples of Front Running
Let’s discuss the following examples.
Example #1
Suppose a broker receives an order to sell five million shares of SAMCO INC in the market. As an outcome of the sale, the prices are likely to have a downfall. The broker sells 1000 shares of SAMCO INC from his account in the market before executing the sales order received. As planned on sales of five million shares of SAMCO INC, the prices fell. The broker covers his short position by buying 1000 shares and earns the profit from the difference amount.
Example #2
An expert has made the report regarding investment about VYOAGE INC, while the report is still needing to be circulated among investors, which clearly shows buying opinion for VYOAGE INC. Keeping in mind after the circulation of the report, many investors will buy the shares of VYOAGE INC, and the stock price will go up. The expert buys 500 shares of VYOAGE INC before the report reaches the investors and earns the profit when the report is circulated, and there is a huge buying of shares of VYOAGE INC.
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How to Prevent it?
The only way to prevent such an act is to monitor transactions strictly and maintaining high ethical standards in dealings. They can be curbed by securities exchange commissions only if they are internally vigilant and committed to doing so. The most important component for preventing front running is strictly punishing such actions. Lack of care or strictness in internal control is the real cause of the losses suffered by investors. A person who manages others’ money has a finite amount of trust, and if this trust once lost, it is hard to earn back.
How Traders Use Front Running?
A trader will use the information of non-publicized order for his interest to gain a monetary advantage. The trader uses the client’s information of dealing in a particular company before placing their order; the trader or broker will place the order on his account.
It results in a broker or trader earning a huge profit when the client’s order is placed, and the share price of that particular company will experience heavy momentum henceforth. In case if an analyst sells or purchases the shares ahead of releasing buying and selling recommendation of their firm to the public with the motive of earning huge profit is also a way of front running used by the broker.
Front Running vs. Insider Trading
- Insider trading is malpractice, where any stakeholder takes advantage of any price-sensitive information about the company, which is insider information at large, to earn huge profits. It is strictly discouraged by exchange the commission and also heavily penalized as other stockholders are at a great disadvantage since they lack important insider information of the company.
- Front running is an illegal act of using information by a broker for trading in securities to obtain profit under his account. Here, brokers have pre-existing information about the orders of investors, which he misuses ahead of trading on behalf of his client investors and gains profit once the investor influences the price of the security.
Advantages
- Front running helps in mass security transactions without impacting price movement by big bull institutional traders.
- Small investors get immensely benefited from such trading activity, although illegal, they earn huge profit within a limited amount of time and with no extra cost.
- The brokers also get a commission if they provide this advice to other clients.
- It’s hard to get traced as it is free from the scrutiny of the exchange commission because it shows a normal trading mechanism.
- Once the bigger transaction is made public, then buying or selling before the client’s transaction is not considered illegal.
Disadvantages
- The whole process is considered illegal and unethical.
- If the client suddenly decides to withdraw the order, the order placed by the broker might seek either a huge loss or no profit at all.
- It may prove disadvantageous for the early investor clients who made the request of the transaction if the share price goes already higher if the broker reveals this news in public.
- If it comes under the scrutiny of the exchange commission, a broker or trader may attract a huge penalty and severe punishment for getting involved in such practice.
Conclusion
Front running is a form of market manipulation done in almost every market across the world. Such trading is considered illegal and majorly undertaken through individual brokers or brokerage firms with the sole motive of earning profits.
It is mostly used as brokers’ tactics related to the transactions done before placing the client’s order or before publicizing relevant information. It is evident that such an act is clearly illegal and can lead to severe punishments and penalties in case caught. One should maintain a high level of ethical standards in their dealings/ transactions.
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