Today we look at the front running. What is it? how is it done? And how does order flow payment (PFOF) fit into the equation?
It was 1928. Wall Street brokerage houses were booming.
Everyone who was someone had a friend who was either a realtor or an investor on Wall Street.
Telephones were pretty commonplace, and reading the tape in search of the next big winner was the connoisseur’s favorite pastime.
As soon as you found the closest “horse” you would call yours estate agents Let him buy shares in that company.
Occasionally, when the broker has been too excited or hard of hearing, another broker on the floor may overhear this Major orderThen he hastily scraped off an order for himself and did not run to the trading counter as usual to try to fulfill his order before that big order came in, and he certainly raised the share price.
He had just headed the stock.
Today, in the computer age, paper orders being routed (or filled) to a commercial counter are a thing of the past, but the idea of taking a non-public message and trying to capitalize on it is still something that goes on.
And the term front running still implies the idea of using information before it is fully public.
In and of itself, trying to use information before “the world” joins in is at the heart of a capitalist society.
There is nothing wrong with discovering a new diet that sheds pounds faster and safer than other diets and trying to make money off of it.
However, if you work for a research company tasked with determining the effectiveness of this diet and then quit to try and release your own version of the diet before the other one ends their attempts, you are no longer “right” .
In many ways, front running is similar to insider trading.
The only real difference is that in insider trading, the person with the knowledge works / owns the company.
Up front, it is the broker who has the information and tries to benefit from this knowledge before placing the customer’s order.
Or, as in the diet example, it could be a stock analyst who is about to make a strong buy recommendation (for example) on a company but decides to buy some stocks before the recommendation is published.
And yes, as you can imagine, such front running is illegal.
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If front running is illegal, why are we talking about it?
Well, not that fast. From the perspective of an analyst, a broker, or an insider, front running is illegal.
However, there are certain circumstances that are gray areas that are considered technically legal.
And there are other circumstances that are considered completely legal.
Let’s say you are the analyst.
You just discovered that XYZ stock has great fundamentals, and based on other technical analysis, the stock is at a very good buy point.
You are about to make a “strong buy” recommendation to the public, but before doing so, buy some stocks for yourself. Up to this point what you did is illegal.
However, if you make the recommendation now, you will fully disclose that you bought shares in XYZ before giving the reasons for your strong buy recommendation.
Because you announced that you could make a profit by increasing stock XYZ In front If you make the actual recommendation, it is technically “legal”.
I am not here to (and will not) debate whether or not I agree with this.
As of now, it is what it is and it has been considered legal.
Another gray area concerns the practice of Pay For Order Flow (PFOF), which is most commonly carried out by high frequency trading companies (HFT).
To unpack this, let’s go back to the original shape of the front barrel …
Instead of a single broker trying to run a run before a big deal, the PFOF model is similar to the brokerage company that takes all of the receipts with orders (the order flow) and collects them in order to sell those orders to another company.
This other one [HFT] The company can then “review” these orders and decide whether it will create a market for these deals (ie, take the other side) or pass them on to another broker.
Why should that make a difference?
In the broadest sense, institutional orders (also known as “smart money”) are usually high, hundreds of thousands to millions per trade.
Retail orders placed by the public (also known as “dumb money”) are typically for significantly lower amounts.
Retailers are likely to be less informed than institutional traders, and since institutions actually “move” the market (due to their large trade size), HFT companies can easily distinguish between the two types of orders and decide where the smart money goes and then take which Opposite of all retail stores that go against smart money.
That was a lot to process, so let me clarify a few: BIG acts in one direction and SMALL acts in the opposite direction.
HFT firms see both deals (due to PFOF), so they know that creating the market for these small businesses is a relatively “safe bet”.
The small trades go against the smart money, that is, if they are against it youYou place trades on the same page as the smart money.
It is like this: the enemy of my enemy is my friend.
You may think so, but no.
They don’t know who the orders are from, even if they have a good “general sense” of what type of trader they are.
They give a “good price” on the spread, which makes the retailer happy, and they make a profit when the trade goes in the direction the institutions want, so they are happy.
If the trade happens to go against them, it is for the small amounts of those trades.
In other words, the HFT companies act like the “house” of a casino.
Chances are the trades they are making the market for are the retailers.
Retailers don’t win that often.
In the long run, the few losing trades that the HFT companies make are nothing compared to the vast majority of trades that are winners.
The house always wins [in the long run]. It is the “whales” that you have to keep an eye on in order not to lose too much.
By avoiding the big trades, HFT companies can essentially avoid the “whales” and keep their share of profits (and therefore profits) incredibly high.
Is that just the same old story another day?
There is no question that the two are very much similar.
There are some rules and regulations that require brokers to disclose the practice of PFOF.
This is especially what has been said Robin Hood in some hot water recently when she failed to do this on her “How do we make money?” Page.
What makes PFOF legal is again related to what you do up front. However, Auto Ads “Terms and Exclusions” are also required.
How are “known side effects” to prescription drugs.
But where can all this information usually be found?
In super small fine print, you need a microscope to read.
And who is reading this anyway?
Maybe you after reading this.
What most front runners do “wrong” is the fact that the person has “hidden” (non-public) information that would certainly affect the price of a stock, and that’s it with this information for themselves before it’s public.
But what if there was a way to use public information to jump into a stock?
In fact, there are many ways to do this.
One way is to track depth of market and determine reasons why a particular stock might go up (or down).
Depth of Market, sometimes referred to as Level II market data or the order book, shows more detailed information on the number of stocks being offered at a given price, regardless of whether they have been filled or are waiting to be filled.
This information is public in that anyone who wants it can have it, although it is not always free.
There are many ways to track the stock market, but one of the most common ways is by looking at or following an index.
Three of the most popular indices are the Dow Jones Industrial Average, the S&P 500, and the NASDAQ Composite Index.
An index is nothing more than a hypothesis Portfolio is intended to show a specific market segment.
There is no way to “own” a particular index. However, means have been put in place to mimic the behavior (movement) of these indices.
When a particular stock is added to (or removed from) an index, the relevant funds must add (buy) or possibly subtract (sell) stocks of that company.
In addition, certain indices are weighted. If a particular stock is actually outperforming or underperforming, the fund may need to adjust its holdings to better match the index.
As a result, you can “predict” what – at least in the short term – will happen to the price of a particular stock.
Index funds are not always able to trade on the same day that an announcement is made. As a result, there will be a “delay” between the time the Index announces the change and the time the Funds can adjust their holdings accordingly.
This gives the savvy investor time to get in (or out of) a particular stock before the funds make their adjustments.
Another possible route to the front run is based on news.
This is generally not as predictable, but often when a company is offered the purchase, the share price goes up.
Or if, for example, a pharmaceutical company announces cheap drug studies, its inventory often increases (at least for a short time).
The outcome is a different form of news, but often the hardest to predict when it comes to how the stock will react.
Stocks don’t always react to news (and especially profits) in predictable ways. Hence, you should be careful when basing your trades on news or profits.
Front run has many different faces, not all of which are positive.
The main difference is how the information was obtained and whether or not it is available to the public at the time the trade was made.
If it’s public, it doesn’t hurt to beat the crowd.
If it is not public, or if you are in a position where you act on behalf of a client – and present the client with a personal trade – then you’ve got off the freeway and are on illegal highways.
Disclaimer: The information above applies to For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.