The Indian stock market is witnessing record trading volumes where new investors are entering to make profits on various instruments. It is a known fact that the stock market is a place of volatility and creates a price change owing to different demand and supply levels. However, new investors and traders are unaware of certain phenomena that can force them to incur huge losses in the stock market in seconds. One such phenomenon is Freak Trades.
What are Freak Trades?
The Indian stock market witnesses numerous surprises concerning the price of a security. A freak trade is a stock market phenomenon where the price of a stock market investment instrument, such as options, equities etc., erroneously rises or falls for some seconds only to return to its original price level.
Such freak trades can happen in the stock market and are the most common with the included stock market indices. For example, a freak trade in NIFTY can force investors to experience a high level of temporary volatility where they can either earn or lose a significant amount because of the securities’ price falling to surprising lows.
For example, in October 2012, a trader created high volatility in the stock market after mixing up the volume and price columns. The mix-up triggered a massive sell order of Rs 650 crore worth of NIFTY stocks and sparked a drop of 15% in the value of NIFTY within several minutes of placing orders.
However, freak trades may not always help investors as they can be highly negative, forcing them to incur hefty losses.
For example, on August 20, 2021, the call option contract for NIFTY, which had a strike price of Rs 16,450 for August expiry, rose unexpectedly from Rs 100 to Rs 803.05 (over 800%) due to a liquidity issue. This caused a freak trade in NIFTY, negatively affecting many investors' investments.
In essence, where the securities’ price follows tremendous short-term volatility, the trades are unintentional and not caused due to natural demand and supply factors. On the contrary, the reasons for such an erroneous trade are a mix of digital and human factors.
Freak trade and trigger in Stop loss Market orders
Almost all investors use a stop loss when placing a buy order in the stock market. A stop loss works as a mechanism where the securities are automatically sold if the set stop loss limit is triggered, meaning that the current security’s price reaches the set stop loss price. One of the most negative factors of freak trades is the triggering of stop-loss market orders. If the security price unexpectedly rises or falls, it may trigger the stop loss orders where it is highly likely for the order to be executed away from the last traded prices.
Consider the example of the freak trades that happened on August 20, 2021, where NIFTY, which had a strike price of Rs 16,450 for August expiry, rose unexpectedly from Rs 100 to Rs 803.05. In such a case, the volatile scenario likely triggered investors’ stop-loss market orders set at Rs 120-200 by investors, forcing them to incur huge losses as their orders were executed away for the last traded price.
How Do Freak Trades Happen?
Although rare, freak trades happen in the stock market for several reasons, often due to technical glitches or human mistakes. Here are the reasons such trades happen in the stock market:
● Manual Mistakes: These blunders happen when investors or traders make mistakes while executing stock market orders. Commonly termed fat finger trade, such trades see the investors or traders entering a wrong quantity of securities, execution price and other order-related factors.
● Technical Glitches: They occur when the algorithm used to place orders witnesses some coding problem, resulting in the execution of bad trades. Since the orders are placed quickly and continuously, the results create high volatility.
● Stop-Loss Orders as Market Orders: When stop-loss orders are placed as market orders, the traders and investors are usually away from the screen without monitoring the market volatility. In such cases, the market orders, which should be executed immediately at the current market prices, increase the chances of freak trades, especially in option contracts.
What is a Fat Finger Trade?
A fat finger trade is a freak trade that is the result of a human mistake made by an investor or trader while placing an order. A fat finger trade generally happens because the trader enters the wrong quantity of the securities while placing the market order.
For example, if a trader wants to buy 500 quantities of NIFTY 15670 CE but enters 5,000 in the quantity section by mistake, the trade is called a fat finger trade. Such trades were common in the past as traders and investors wanted to execute as many market orders as possible in a short time.
The exchanges introduced a quantity freeze rule to regulate the set quantities of purchase and mitigate fat finger trades. The single order freeze quantity for Nifty, Banknifty, and Finnifty is 2800, 1200, and 2800 respectively.
How To Protect Your Investments?
Now that you know the freak trade meaning, you must have realised that such trades will continue to happen as traders compete to execute more orders. However, you can follow the below steps to protect your investments against the sudden rise and fall in securities’ prices:
● Higher Limit Order Than Market Order: When buying securities, especially derivatives contracts, you should always use a limit order and set its price higher than the last traded price or the touchline. You can also put the market price 3–4% higher than the best sellers, as other traders may buy at the market price if the prices are moving fast.
● Use Stop-Loss Limit and Stop-Loss Market Orders: It is common to place stop-loss orders as they are useful to protect investments. However, you should use the stop loss limit (SL-L) order type to set the trigger price and the limit price. It will help shift the order to a limit order if the freak trade triggers a stop loss.
Investors and traders trading in the stock market should be cautious of freak trades as they can force investments to lose significant value quickly. Hence, It is essential to understand what is freak trade in the stock market and how you can protect your investments against such unexpected situations. It is always wise to constantly monitor your investments and ensure that you can adjust them in real-time if such events happen in the stock market.
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