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Front-running is an investing strategy that anticipates the impact of upcoming trades on the price of a security. It is illegal for brokers or asset managers to practice front-running using trading information about their own or another broker's clients, and this is punished by the Securities and Exchange Commission. However, front-running is not always illegal, and investors can use this strategy to make a profit based on the predictable effect of a certain transaction on the price of a stock.
In front-running, a trader will take a position in an equity just before a brokerage takes a position that will cause the stock to move in a predictable way. The most common example of front-running is when an individual trader buys shares of a stock just before a large institutional order for the stock which will cause a rapid increase in the stock's price. This information can be obtained legally through monitoring the bids and asks on the market and the investing transactions of institutional investors like hedge funds. It can also be obtained illegally, such as when the research analysts of an investment bank pass insider information to the brokerage arm of the business, or when a money manager takes a position in a stock before convincing a client to make a large investment in that same security.
[edit] Examples of Illegal Front-running
Front-running can be done illicitly by a brokerage, which can profit using insider information
- Example 1 - Billitkoff Investment Securities, LTD is about to sign a new client, Mary Moneybags, to its large-cap hedge fund. Billitkoff buys 1,000 shares of Apple (AAPL), then signs Ms. Moneybags and convinces her to invest 50% of her new portfolio in technology stocks. Billitkoff Investments then buys 100,000 shares of AAPL with the capital from the new account, driving up the price on the 1,000 APPL shares it's already holding which it keeps as a profit.
- Example 2 - Silverman Investment Bank's equity research division is about to publish a "strong buy" recommendation for Kraft Foods (KFT). Silverman's brokers, acting on a tip from the company's analysts, buy 100,000 shares of KFT shortly before the analysts publish their recommendation. When the market reacts to the buy rating from the research division, Silverman's brokerage profits from the KFT shares it is already holding.
[edit] Examples of Legal Front-running
Front-running is not always illegal, but could be considered unethical or a "parasitic" type of investing where profits are made from anticipating or reacting to another broker's trading patterns.
- Example 1 - A common example of front-running is called "penny jumping", and can be done when a broker places a large buy limit order for a stock. Let's say Blueblood Partners puts in a buy limit order for 50,000 shares of Exxon Mobil (XOM) at $80.00. Another trader - James Buyback - sees this and puts in an limit order for XOM for $80.01. Mr. Buyback has used front-running to limit his risk - if XOM's price rises above $80.01, he'll profit, but if it doesn't he'll be able to sell for $80.00 as part of Blueblood's large limit order.
- Example 2 - John C. Futures is a trader, and he sees that his broker colleague Andrew Long has just bought 10,000 shares of Dryships (DRYS). Mr. Futures knows, from past experience, that Mr. Long often buys all of the competitors to a particular company shortly after buying that company's stock. So he buys dry bulk shipping stocks like Genco Shipping (GNK) and Diana Shipping (DSX) in advance of Mr. Long's large orders for these same stocks. If Mr. Futures made his front-running trades simply by reading his colleague's past habits and predicting his next move, he's done nothing wrong. However, if Mr. Futures found out that Mr. Long was about to buy GNK and DSX directly from Mr. Long or an employee of his firm, this would be an example of illegal front-running.
- Example 3 - Sometimes, with a very large market orders, simply exposing the order to the market allows for front-running as traders sell positions that may become unprofitable. The opposite is also true, and a large buy can encourage front-running as traders buy in ahead of the large order. let's say that Alpha Investments, a hedge fund with a $100 Billion portfolio, wants to shift 10% of its portfolio into Visa (V). It can't buy $10 billion in V stock all at once, so it must do so gradually, in installments. Other traders watching Alpha's activity can anticipate that Alpha will continue to buy V, driving up the price, and front-run by purchasing shares in V ahead of this order.
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