Front-Running Definition, Example, and Legality

What Is Front-Running?

Front-running is trading of stock or any other financial asset by a broker who has inside knowledge of a future transaction that is about to affect its price substantially. A broker may also front-run based on insider knowledge that their firm is about to issue a "buy" or "sell" recommendation to clients that will almost certainly affect the price of an asset.

This exploitation of information that isn't yet public is illegal and unethical in almost all cases. Front-running is also called tailgating. 

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 wasn't 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 firm rather than inside the client's own business.

Exploiting Analyst Recommendations

Another tactic for front-running is acting upon an analyst recommendation that hasn't yet been published.

The research analysts work in a separate division from the broker and concentrate on evaluating the potential of individual companies 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 gray 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.

Index Front-Running

A form of front-running in index funds is common and isn't illegal.

Index funds track a financial index by mirroring the index's portfolio. The composition of the index changes periodically 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 isn't illegal because that information is available to all those who are paying attention. 

Example of Front-Running

In 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 over-the-counter (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.

In a single sample month, FINRA found that Citadel had traded against its 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.

The Bottom Line

Front-running involves the trading of stock or any other financial asset by a broker for their own account when they have inside knowledge of a coming transaction or development that is about to affect its price substantially. This can also happen when an investment broker has insider information that their firm is about to issue a positive or negative research recommendation to clients that will almost certainly affect the price of an asset.

Front-running is illegal and unethical when a trader acts on inside information. However, it can sometimes happen and be legal if an investor buys or sells a stock and then discloses the motivation behind it in attempt to be transparent and honest about the transaction.