On 20th Aug’21, derivative traders got to experience an unusual activity in some option contracts of Nifty and Banknifty.
The call option contract of 16450 CE of Nifty for the August expiry spiked from Rs. 100 to Rs. 800.
Similarly, 37000 PE option contract of Banknifty rose from Rs. 1 to make a high of Rs. 2,040 within seconds.
Due to this freak trade, a lot of traders faced the consequences in the form of heavy losses.
This happened majorly due to the removal of TER(Trade Execution Range) mechanism by NSE on 16th Aug’21.
What is Trade Execution Range Mechanism?
As the name implies, TER is the price range between which option contracts could trade. The price range is set by the exchange as a risk management measure to ensure that no market order gets executed when prices go beyond this range.
For example, if a Banknifty call option is trading at Rs. 300, then no market order will be executed beyond 40% of this price on both sides. That means the TER for this call option will be [180, 420].
Why was this removed by the Exchange?
This risk management mechanism brought a new problem. Since, the range is set by the exchange manually, any large move in that particular option during the day or even during the market opening meant that the option could not be traded till the exchange manually changes the range again.
This is a difficult situation for a trader because of the inability to enter or exit a trade. The exchanges received a lot of complaints regarding the same and thus decided to completely remove this mechanism.
How did the loss actually happened?
So, lets say you are an option seller and you are short 16450 call option @100. You set an SL-M order(stoploss – market order) at 50% of your short price i.e., @150. That means, if there was no freak trade and things went south for you, the maximum that you could’ve lost in this trade would be Rs. 2,500 per lot.
Once the price touches 150, it would just look for the next traded price to execute your market order. Due to the freak trade, the traded price went as high as Rs. 800, a slippage of almost 650 points and that is where your market order would’ve got placed making you a loss of Rs. 35,000 per lot.
What can we do to avoid losses by such freak trades?
1. Use SL-L instead of SL-M
The first measure that you can take is to make sure you always have SL-L (Stoploss Limit order) instead of SL-M orders to avoid such high slippages and thus the loss. This makes sure that your slippage or the impact cost is limited to a certain points(in this case 10) only which is the difference between your trigger price and limit price.
The stoploss order gets sent to the exchange when the trigger price crosses 150 and you have a buffer of 10 points to execute your trade. So, if there is a seller at 155, your trade will get executed @155.
But, there is a caveat with this approach. What if there is no seller between 150 and 160 and the traded price jumps to say 170 directly from 150?
In this case, your SL-L order will get skipped and you might face huge m2m loss because of your stoploss getting skipped. What can we do in such a situation?
2. Wait for 10 seconds
The assumption here is that the freak trade is just for some seconds and things should become normal after a few seconds of chaos. So, if the price jumped to say 200 directly from 150 due to illiquidity in that strike price, it should come back to the point where there is high liquidity, i.e., near our stoploss.
Thus the next step is to wait for 10 seconds to see if this was a temporary freak or not. Most likely, the traded price will return back and our SL-L order will get executed.
But, what if the freak is not temporary?
3. Use LTP to place a new Limit order
The only option right now to save your trading capital is to cancel your previous limit order and place a new limit order based on current traded price.
So, if the LTP is say 200, place an SL-L order with a trigger price @203 and limit price @210. You can decide the buffer for both your trigger price and limit price.
Trading is not a get easy rich profession. There are so many things that are not in our control. What we as traders can do is to manage our risks better because that’s the only thing that we can control.
If you want to go deeper into this, watch this conversation with a trader who lost 30% of his trading capital due to this freak trade.
Remember, these are not fool proof measures to avoid losses due to such freak trades. We are not SEBI registered and these are just the ideas for educational purposes. Please do your own research before executing any of these measures.