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Reading through examples of legal front running, I'm struggling to understand how "penny jumping" (http://www.wikinvest.com/wiki/Front-running) can be profitable.

Suppose stock ABC is trading at a spread of \$50.1 - \$50.9 and trader Alice has placed a very large day buy order at the \$50.1 level. Trader Bob who is supposed to profit and limit his risk is placing an order at \$50.2, one tick up.

Now your typical description would say something like: "if ABC's price rises above \$50.2, Bob will profit, but if it doesn't he'll be able to sell for \$50.1 as part of Alice's large limit order."

Down: This is a buy order, so if the price goes down it is because there is sell pressure, and sellers are eventually crossing the spread. When Bob's buy order has traded he can still scratch trade by selling back against the impenetrable $50.1 bid level, and he didn't lose much. His risk is indeed limited.

Up: (Here's what I don't understand.) If the price goes up it means more bidders are joining the queue on the bid side pushing the levels up above \$50.2 where Bob's order resides. Bob's order will not get done at all - where's the profit here? We'll simply discover by the end of the day from the average close price that "ABC went up".

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1 Answer 1

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In the Up scenario, there is not one possible outcome. There are multiple possible outcomes within Up. This could be (i) fill and price goes up, (ii) partial fill and price goes up, (iii) no fill prices goes up.

All three outcomes have positive value in expectation, with that value descending as we go from (i) to (iii). The third outcome is profitable in expectation as well because we have front-queue position which is very valuable assuming the tick size isn't too small, which it doesn't seem it be if that trader is placing 10 cents above the inside.

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I am close to accepting this answer but a significant portion of my question, which is exactly about case #3 is unanswered - "Bob's order will not get done at all" - how is this front queue position valueable? The example used a day order. –  user6930 Jan 10 at 9:19
    
@user6930 The front-queue order is valuable because the future price does not have a lower bound that is greater than $\$50.2$. There is a non-trivial probability that the price will come back to $50.2 in the short-term, perhaps 40% chance before the end of the day, and under this 40% chance there is a more than 60% chance of a favourable fill. Here the profit lies. Queue position is valuable because even if the 'true price' is higher, there is a probability that you will get filled before the price actually does tick up, allowing you to ride the up-tick that a back-queue order can't get. –  user2763361 Jan 10 at 9:20

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