Are freak trades the new normal in Futures and Options segment?

In the last couple of weeks, 'freak trade' has become the talk of the town as there have been multiple incidents of its occurrence in the futures and options (F&O) segment. 

In this article, we shall deep dive into how it happened and what measures one needs to take to avoid such freak trades.

It all started on August 20, 2021, when NFITY 16450 Call (CE) option premium defied gravity and skyrocketed from levels of Rs 100 to Rs 800 levels in the blink of an eye. This sudden violent move stunned most of the traders with many suffering huge losses.

Why does a freak trade happen?

Consider a trader who shorted the 16450 CE strike at Rs 100 placed a stop loss market order at around Rs 140 to cover his short position if the market reverses. As soon as the market goes to Rs 140 level, the stop-loss orders would be sent to the exchange order book and scan for a buyer who is ready to buy, whatever the price he quotes, this order would be sold to him.

During the normal days, if a stop-loss order is sent for Rs 140, it gets executed around the same price with + or - few rupees of difference. However, on August 20, 2021, this was not the case, because as soon as the price crossed Rs 135.8 level, it shot up to as high as Rs 803.05 with 6000 lots getting executed around this price. This mainly happened due to a lack of liquidity, that is, a lack of buyers beyond a certain level.

Here is the screenshot of NIFTY 16450 CE OPTION

Imagine a guy who shorted Nifty 16450 CE option at Rs 100 with stop loss at Rs 140. However, due to lack of liquidity, once the price moved 135 levels, the bid/ask spread moved wildly from Rs 150 to 800 levels. So, for all users who used the stop-loss order, the moment the price crossed Rs 135, it started exiting at the next available best price which varied from Rs 150 to Rs 800. In short, within a fraction of a second, all the stop-loss orders exited at a much higher price.

For example, a trader who shorted at Rs 100 with a stop loss of Rs 140, would have been forced to cover its position at Rs 800. This would have resulted in a loss of Rs 700*50= 35,000 per lot.

Now comes the most important question which has been raised by many traders after such incident, ‘How one should handle freak trade?’

Kirubakaran Rajendran founder of squareoff.in shares his view on the above question.

He says, “It is really difficult for manual traders to handle this scenario, however, Algo traders can easily handle it. They must use SL- Limit order instead of market order with a one per cent buffer between trigger price and price. But there is a chance of your order not getting filled if the market jumps suddenly and kept on rising. So, you should set up an alert with tools like SENTINEL where you could set up your stop loss trigger level, if the market crossed your stop loss level, it will send you an alert, then you can check your broking account and ensure the order is exited on time. This way, you don't need to sit in front of the system throughout the day and can also ensure your stop-loss orders are exited.”

He further adds, "freak trades don't last more than 2 or 3 seconds. After a sudden spike, it cools off and the order flow gets stabilized. But all the traders who use stop loss-market order get butchered in those two/three seconds." 

"At squareoffbots we follow limit modifier functionality to handle these freak trades for algo users. Here stop-loss orders are executed as stop-loss limit orders as the algo will wait for 30 seconds to get filled, if not filled then it converts into a market order and ensures it is exited. The freak trades are the new normal. Instead of blaming the NSE or regulatory bodies, we need to accept it and adapt ourselves with proper risk management setups and stop using stop loss market orders."