04/12/2022 — Frontrunning (A Crash Course)
Perhaps you have heard of this trading term, or maybe it’s new to you. Regardless of one’s level of understanding, the practice is patently illegal, even if a detailed analysis of daily market activity might suggest otherwise.
Please forgive the aggravated tone of the following musings. Hopefully the rationale behind the attitude will be apparent by the end of the tutorial-rant hybrid that follows.
I got frontran (apologies for the pidgin floorspeak, I don’t know how else I’d convey the idea) at the end of last week on a trivial, but still infuriating order that will serve as both the antagonist for the anecdote and the cornerstone of the lesson. This past Friday, April 8th, at 10:14 AM I happened to be scouring the expirations and discovered a .05 bid for only 5 of the April 14th, 3175 line puts. The closest .05 bid at the time was 3350, so being 1250 points away from the current underlying of 4450, and only six days out, I felt that the distance/time/price “triangle of risk” was acceptable to me for only 5 lots. Part of its allure was a trade that I could make and defend on a slow day. Normally I’d advise against boredom trades. I still do. But, I also enjoy doing things I shouldn’t do — it’s one of life’s great pleasures!
My plan was to put in a bid up around the 3350 level to spread them off for a free look at 175 points, that while surely would never threaten to land in-the-money, might appreciate somewhat if I were to catch one of the recent mini-panics that appear weekly in the current market. If not, I could wait until Monday, spread it then, or just walk away with the decay in-pocket. If this all sounds a bit much for a 5 lot, it is. Did I mention this was a boredom trade on a slow day?
The heart of the story begins when I recheck the market 15 minutes later and see that the same expiration, 3075 line is now .05 bid for 1,000 options. I got frontran. To be fully fair and honest, I must say that it is within the realm of possibility that a random punter put in a random bid 15 minutes previous to this sizable order. It is possible that through his wholesome innocence the option gods smiled upon him and granted him a riskless spread…it’s doubtful.
More likely, the 5 lot bid that “picked me off” knew of the impending order and took it upon themselves to engage in illegal market activity, namely frontrunning. With the knowledge of the upcoming order to buy a thousand options at a lower strike price, it makes perfect logical sense to position oneself to buy something better knowing that they will soon be protected. It’s a riskless trade, but completely against market rules and regulations. Riskless trades themselves are not impermissible. Legging into long butterflies for a credit and trading certain “boxes” (way before my time) are just two examples that are perfectly legal, even if difficult to execute.
However, market participants are not permitted to deal upon advance information provided to them. One of the fundamental tenets of a fair and open marketplace, at least in theory, is that all parties have access to the same pertinent information. This is not equivalent to having a hunch, or engaging in strategic arbitrage. Those are perfectly acceptable tools of trading — in some sense, they are necessary precursors for successful operation. When people frontrun orders, they capitalize on an unfair and illegal advantage, thus depriving their counterparty a fair chance, and more importantly, they erode trust in our financial markets.
No one is going to care about a 5 lot. I could file an Unusual Market Activity complaint, but I am sure that like the many I filed during my time trading in the VIX pit, it would surely find a quick demise in the circular file. The exchanges have very little incentive to pursue any investigations from activity from which they profit. After all, to them, a trade is a trade. They harvest commissions and fees, and they can turn a blind eye, leaning upon the possible coincidence that does from time to time occur in a marketplace that executes millions of transactions a week.
So what about the Securities and Exchange Commission (SEC)? Can’t they step in and hold traders, or at least exchanges, accountable? That’s unlikely. For one, they are woefully underfunded when considering they fight in an industry where money is the ends that justifies the means, which justifies the ends. That’s not their fault. However, they misallocate their resources and often act with an ineptitude of legendary proportions. The SEC only functions well as a gavel, striking the final blow after all the work has been done by a more competent and vested third party.
This may all sound depressing, but all is not lost. There exists a simple, if quaint, solution to this problem.
Don’t be a frontrunner.
Sure it may sound more fitting for a junior high classroom discussion, but then again, this blog is called “Fifth Grade Finance.” Frontrunning is wrong, it’s cheating, and when exercised on a large scale, it damages confidence in our financial systems, which, contrary to some wild radicals, are essential to our prosperity. Beyond that, although rare, once in a while examples are made of frontrunners, and it is a financial crime! The cost-benefit, risk-reward of frontrunning does not add up. If one is numerically fluent enough to trade in these products, they should be able to deduce this for themselves. It’s wrong, it’s dangerous, and if it’s what one relies on to butter their bread, they might want to consider a better means of procuring said butter and bread.
So now you know about frontrunning. Please refrain, if only to alleviate this author’s heartburn.