Front running is a term used in financial markets to describe the practice of taking advantage of advanced knowledge of upcoming trades to make a profit. In options trading, front running occurs when someone buys or sells an option contract based on information they have about a large order that is about to be executed in the same underlying security.
This is a common tactic used by traders among social media with a large following, of which are relatively new to options trading or the stock market itself. To understand front running options contracts, it is essential to know how options trading works. An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying security at a specific price on or before a specific date. When someone buys or sells an option contract, they are taking a position in the market that depends on the underlying security's price movement. Options contracts can be bought and sold just like stocks, and the price of an option is determined by several factors, including the underlying security's price, the expiration date, and the strike price.
Here is an example of what front running looks like with options contracts.
1. Trader A will use posts on different social media platforms to start up "hype" around a certain stock.
2. Trader A will then purchase options for a stock (for illustration purposes we'll call it $XYZ) for a low amount, perhaps $0.15 per contract.
3. After purchasing for $0.15 per contract, Trader A will then utilize their social media following with "callouts" such as "$XYZ is going crazy! I'm buying calls for $0.20 per contract."
4. Immediately after posting, followers on multiple social media platforms then see the callout of "$0.20 a contract" and immediately start to purchase it. Even with the price at $0.15, followers will think they're obtaining a "good deal" since the callout was at $0.20.
5. Due to the low volume of these option contracts and dependent on the following Trader A has, these contracts will spike upwards of 50%-100% within minutes due to the amount of money being put in by Trader A's followers.
6. What most followers don't know, is that Trader A already has a sell order at $0.20 for most of their contracts, which they already bought at $0.15. Within minutes, or in some cases seconds, Trader A has now made a 25% ROI by dumping their contracts onto their followers.
The practice of front running options contracts is illegal and considered a form of insider trading. The Securities and Exchange Commission (SEC) has been cracking down on front running in recent years, and traders who engage in front running can face severe penalties, including fines and imprisonment (see Atlas Trading). The SEC has also introduced rules aimed at preventing front running, such as the "Information Barrier Rule," which requires broker-dealers to establish information barriers between different departments to prevent insider trading.
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