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Suppose I have placed an order to buy 100 shares at $10. Can my stock broker leave my order aside while it buys 100 shares at $10.01 using its own money? The stock broker gains from this:

  • If the stock price subsequently rises, the stock broker can sell its 100 shares at a profit. However, my order will not be filled.
  • If the stock price subsequently falls, the stock broker can sell its 100 shares to me at a small loss of $0.01 a share.

In this way, the stock broker gets a small downside (due to my order $0.01 below the price the stock broker paid), while getting a theoretically unlimited upside. The earnings from such operations probably allow stock brokers to reduce the commissions that they charge to clients. In practice, do stock brokers do this to earn money using their own account? Is this disadvantageous to me in any way?

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This is called front running. Whether it is legal or not depends on whether it is based on public or private information. If a broker does it on the basis of a client's order, it's unethical, illegal, and subject to all sorts of sanctions, though certainly not impossible. If a high frequency trader (HFT) pays for fast computer access to multiple exchanges, and your order cannot be filled on a single exchange, it's entirely legal for them to observe your order come in on one exchange, and front run it on other exchanges, taking advantage of their faster connection and superior computer power.

Ordinary retail trading in individual stocks doesn't usually have to worry about this. Nobody is going to front run a tiny order of 100 shares. Front running only makes sense when orders are so large that they will move the market. Also, small orders are typically filled on a single exchange, so there's limited opportunity for a HFT to insert themselves in the trades.

There is an issue for retail traders investing in mutual funds. Mutual funds do place huge, market moving orders, which pull shares from multiple exchanges. These trades are vulnerable to front running by HFT, driving up the costs of the purchases, and marginally reducing the returns of retail buyers of the fund. Whether this is fair or ethical is a matter of debate. Some claim that the exchanges are essentially selling HFT the right to "tax" high volume trades. Others claim that HFT is no different than the other tools traders have used over hundreds of years to gain an information advantage. One hundred years ago it was access to a trans-Atlantic telegraph line. Now it's a private optical fiber link to the exchange.

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The front running tactic you have described is known as "penny jumping", "order matching", or "quote matching".

In the USA, the specific case described in the question is explicitly prohibited by FINRA rule 5320. Prohibition Against Trading Ahead of Customer Orders (informally known as the "Manning rule"):

(a) Except as provided herein, a member that accepts and holds an order in an equity security from its own customer or a customer of another broker-dealer without immediately executing the order is prohibited from trading that security on the same side of the market for its own account at a price that would satisfy the customer order, unless it immediately thereafter executes the customer order up to the size and at the same or better price at which it traded for its own account.

[...]

Summary in simple English:

Plain speak: Broker-dealers cannot use their knowledge of customer orders to make money for their own accounts without satisfying the customer's order.

(Source: https://www.otcmarkets.com/learn/market-101/regulation)

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    Why am I always downvoted when I answer my own questions?! This must be the fourth or fifth time this has happened in a row.
    – Flux
    Aug 27 '20 at 15:13
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    Flux, these SE sites have erratic / bizarre downvoting. (And indeed upvoting.) Among a number of issues is "velocity" voting, political voting, personality voting, voting for apparently-researched-but-wrong answers, etc etc. Some of the sites (like English SE) are known for amazingly, hilariously, oddball voting. This site isn't as bad as some! You just have to completely ignore it.
    – Fattie
    Oct 1 '20 at 11:04
  • @flux, don't worry - I upvoted you! (smile) I think your answers (and fattie's) are always interesting and insightful, so I enjoy reading them. Personally I think people should have to supply a reason for downvoting. I agree that it sometimes seems "political" or like a popularity contest.
    – RiverNet
    Apr 20 at 21:45

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