Front running, insider trading, pump-and-dump and misuse of information are not uncommon in the equity market. In this article, we will be discussing what is front running and how it works in the stock market.
Front running is an illegal practice where certain individuals enter into stocks or any other financial securities based on advance knowledge of non-public information regarding large pending transactions that will influence the price of the underlying security.
How front running works
Here is an example of front running: say a mutual fund manager or any other person, enters into a transaction from his own account in advance knowing that a large buying is about to take place for the fund. This means, they will take a sizable position from their own account before filing buy or sell orders for mutual funds that drive up/down the price.
After filing the large buy or sell order of the mutual fund, these individuals will exit their position with a huge profit.
Not only fund managers, individuals working in institutions, individual brokers or brokerage firms may also commit a front running violation when they are in possession of valuable information that can drive the price up/down.
For example, suppose a broker receives a large order to buy ABC company’s stock for a client. Before placing the order for the client, the broker lets say, buy 10,000 shares of ABC company for his own account at Rs. 20 per share. After executing his order, he placed the customer’s order which drove the price to Rs 24 per share. Now the broker will immediately sell all the shares of XYZ company from his personal account at 24 per share to make a significant profit of Rs. 40,000.
The main intention of front running is to profit from the big moves either by buying or selling shares.
In this way, front-runners make big money based on the inside information that was not in public domain.
Smart traders instead of making one transaction, will split their total buying into small trades from different accounts to have a sizable position before placing the client’s buy/sell order. In this way, front-running transactions will become more difficult to detect.
Front running is prohibited in many countries including India as it’s considered a form of market manipulation.
Front running is also known as tailgating.
Front running by a mutual fund dealer
The fund manager, after deciding which stock to buy and sell, informs the dealer, who executes the trade on behalf of the mutual fund.
In general, these mutual funds place large orders that can move the market and prices of stocks.
If the dealer wants to profit, he can build a position minutes before he punches in the order of the mutual fund. When prices of the stock rises due to the mutual fund’s buying, the dealer will immediately square off his position to pocket the profit.
In this case, before the order of the mutual fund enters the market, the stock price is already manipulated.
The dealer may not use his personal account to trade. He may use his associate’s and relative’s accounts to avoid getting caught.
How front running is different from insider trading
Front running is generally confused with insider trading but it’s a bit different.
Insider trading refers to a company insider, an official, employee or a senior executive who buys or sells shares ahead of a major announcement on the basis of unpublished price-sensitive information (UPSI).
This means, the insider has taken advantage of possession of unpublished price-sensitive information (UPSI) to make profit in the stock market.
In both the cases, the perpetrator aims to make money on the stock market by trading in the company’s shares due to possession of certain information which can move the future price of the stock substantially.
Front running is quite similar to pump-and-dump scheme, in which a speculator hypes an investment for personal gain after having a sizable position in it. When the crowd reacts based on the recommendation, they square off their position to make profit.
