Traders, seasoned or novice, have always had a peculiar relationship with the idea of stop loss. This is not to say that either of them employed it generously. But, after a loss-making trade, they are like to hear “hindsight” lecturing them how the placing of stop loss order would have prevented a poor trade from becoming a catastrophic one.
Investment gurus also cannot speak enough of the virtues of placing a stop loss order in the system, rather than one in the mind. The logic cannot be any simpler; none of us plan for failure and assume that Lady Luck is always with us. While some others hide behind theories that stop loss orders often get lapped up, before prices turn in their favour, there is also the possibility of wild trades happening at extraordinary price points followed by a quick reversal to normal levels, which is also why some traders pooh-pooh the idea of stop loss. These unnatural trades are the centre point of this article.
Of late, the instances of trades that occur far away from the prevailing market price looks to have increased, reinforcing the beliefs of the naysayers of stop loss. The instances of such trades which are now conveniently called “freak trades” have been high enough recently, that it has piqued everybody’s interest and concern.
Here are a few freak events in the 10 years:
October 5, 2012 : A dealer at a brokerage mistakenly punches in a sell order for Nifty shares (stocks forming the Nifty index) many times more than the actual quantity that the institutional client wanted to sell. Nifty hit a low of 4,888.20, a 15 percent decline from the previous close, and then immediately rebounded to 5,625 (down 3% from the previous close), at which point trading was frozen.
July 5, 2021 : Nifty Futures contract spikes to 16,546 for a very brief period, before settling at 15858. NSE clarified as: “We would like to clarify that on July 5, 2021, at the time of market opening, a trading member’s dealer placed a manual buy order for Nifty Near Month Futures in the first few seconds upon opening of market a price which was significantly higher than prevailing price in the market. Since the order was within the operating range, the order matched with existing sell orders in the order book and two trades got executed at a price within the trade execution range.
July 28, 2021 : Nifty futures for August expiry crashes 5 percent to a low of 15,256 from its opening 15,787 before reverting to normal prices quickly.
August 20, 2021 : The call option of Nifty August 16450 strike rises over 800 percent to 803, while put option contract for Bank Nifty August 37,000 strike rise by over 2000 percent from 1 to 2040.
Fat Finger Error?
In the last ten years, aided by technological improvements that facilitated easier access to trading screens and analysis as well as rising income, participation in derivatives has been systematically rising, and the last year has been a watershed moment in terms of new client enrolments. The plethora of regulatory interventions that constantly changed the playing conditions of the traders, failed to slow down this juggernaut, catapulting NSE into the largest derivatives exchange in the world, in terms of contracts traded.
Infact, the securities transaction tax (STT) collections gave over Rs 12,000 crore to government’s kitty as on September 16, which is a whopping 50 percent jump over last year. So, not only are the number of trades higher, but the revenue generated off it is also higher, and for the same reasons, every single flaw is subject to higher scrutiny and discussed in public. While this does not in any way abdicate the responsibilities of the authorities or systems that we look up to, it is too simplistic to consider fat finger errors as being abnormal. The issue with risk management systems that are designed to deter fat finger errors is that sometimes, it happens at the cost of free flow of the trading.
TER and freak trades
Let us look at the concept of Trade Execution Range (TER) which was incidentally done away with from August 16, 2021. Until then, NSE’s TER methodology meant that orders in the F&O segment shall be matched and trades shall take place only if the trade price is within the trade execution range based on the reference price of the contract. At market open, this reference price shall be the theoretical price based on the underlying price (Using implied volatility in case of options contracts and rate of interest which shall be revised daily with the applicable 30 days MIBOR rate) or base price of the contract in case underlying price is not available at the time of computation.
Similarly, there was also a logic for arriving at the reference price through the day, but reference price derived at open caused problems with the free flow, as sometimes, they were far removed from actual price. Thus, in the event of a large move at open, orders may end up not getting executed if the actual price should be beyond the trade execution range while the reference price remained within the trade execution range on account of being derived from a theoretical price which is oblivious of a new price information or event. While this problem was solved with the removal of TER from August 16, 2021, it threw open possibilities of higher occurrences of wild trades. While this is obvious now, it is fair to say that TER’s removal is not the sole reason for such trades, as they have happened prior to August 16 as well. What is now increasingly becoming evident is that the onus of risk management falls to a great extent on the intermediaries as well as the trader. A case in point is NSE moving towards removing the facility for stop loss market orders in options.
Stop loss Orders at market
When you put a normal order, you are making a informed decision, as you are in front of the trading screen, watching the prices closely. In the case of stop loss orders which are entered as market orders, this is not the case, as you would be mostly away from the screen, unaware of the volatility that is in play. In such cases, the market orders, which are intended for immediate execution at prevailing market prices, irrespective how far they are, increases the chances of freak trades. This is especially so in options, where exaggerated prices are quite possible, because of the nature of the trade.
However, while this brings down the possibility of a loss by way of freak trade, it exposes you to another one, ie extraordinary losses in case of unfavourable market move which is what you wanted to be protected against, in the first place. However, this clearly draws a line between market risk, which is up to the trader, and operational risk, which is up to the exchange, with help from the intermediaries, by way of deterrents and alerts at trading platform level, etc.
All said, technology may have helped to make the trading experience as seamless and effortless as in an e-commerce site, but that should not make the trader any complacent. In other orders, fat fingers do not have a quick fix.
What Is a Fat Finger Error?
A fat finger error is a human error caused by pressing the wrong key when using a computer to input data.