Real-Time Risk

CHAPTER 4Who Is Front‐Running You?

• —What do quants eat for dinner?
• —Depends on their risk appetite.

Many investors feel that someone can see their orders and place orders immediately ahead of them to draw liquidity and capture a small profit at the investor's expense. Often, investors sense that they can observe such market behavior in real time through a brokerage app screen. Take a quiet market; see a specific bid; place a sell order, and the bid evaporates just before the order happens to execute. How can this happen? This chapter discusses the peculiarities of front‐running in the electronic trading world we live in, as well as broader implications of liquidity, order book depth, spoofing, and more.

First, the basics—front‐running is illegal. Front‐running is defined as an activity whereby an ill‐intentioned market participant observes an incoming market order. Knowing that the order is likely to move the price just due to its basic liquidity‐taking property, the observer places a similar order directly ahead of the original investor's order. As such, the observer runs to place an order ahead or in front of the investor with the expectation of taking a better price. Next, the investor's order is executed, possibly at a worse price due to reduced liquidity, courtesy of the front‐runner. Following, the price likely moves further since the investor's order also takes out liquidity from the market. The front‐runner can now liquidate his temporary position and realize a small ...