Trading. To check freak trades, NSE does away with stop loss-market order in options

In a move that could partially address concerns over frequent freak trades, the National Stock Exchange has removed the stop loss-market (SL-M) facility in options contracts from Monday.

Orders placed with SL-M, if any, will be rejected by the exchange with a message “function not available”. The change is applicable only for orders placed in index options and stock options contracts. Stop-loss order with limit condition (SLL) will be available for all contracts, said the exchange.

Mock test

The exchange had tested the functionality in a mock test conducted last Saturday. Nithin Kamath, Founder and Chief Executive Officer, Zerodha, was the first to tweet about NSE’s move on September 18. NSE had declined to comment then.

A freak trade is triggered when a large buy or sell order is ‘erroneously’ placed at a price far away from market reality, triggering the pre-set stop-loss set by investors. Stop-loss is an advance order to sell an asset when it reaches a particular price point. It is used to limit loss or gain in a trade. For instance, if one has an open position in a stock at ₹100 and wants to limit the loss to ₹95, he has to place a stop-loss to sell at ₹95.

Instead of putting a particular price in the stop-loss option, if one chooses SL-M, it gets executed as a market order at the best available bid price. In the event of freak trade, the order gets executed, leading to a huge loss for investors.

For instance, if Infosys trades at ₹1,700 and one puts ₹1,680 as a stop-loss market order, the order will get executed once the price hits and dips below ₹1,680. If a freak order is at ₹1,500, the possibility of stop-loss market order getting executed is high. On the other hand, in a stop-loss order at ₹1,680, the order will first get triggered and sent to the exchange; it will not be executed immediately. The order will get executed at the available best price. As in the case of a freak order where the price dips and recovers sharply, there is a high possibility of the stop-loss order not getting executed. However, the loss could be more if Infosys declines further from ₹1,500 in the stop-loss order.

Anand James, Chief Market Strategist at Geojit Financial Services, said the removal of SL-M will not stop freak trades, but will reduce the number of trades getting exposed to such freak trades, as fat finger errors cannot be entirely avoided.

The other aspect is that the restrictions have not been placed for futures. Recently, freak trades have been noticed in futures of Reliance Industries, TCS, HDFC Bank, HDFC and Bharti Airtel.

Risk management

Asked why the exchange has not removed SL-M in futures, James said it is logical for the exchange to focus on risk management measures on options, as majority of the recent freak trades occurred in this segment and investor participation in options is also rapidly rising. The number of options contracts traded in August was 45 per cent higher compared to April but index futures’ participation saw an 18 per cent decline in the same period.

Incidentally, the contracts traded in the index options segment are now over 200 times more than that in the index futures segment. Fall in investors participation also aggravates chances of freak trades, James said.

Freak trade in the NSE derivative segment has become a recurring event ever since TER (trade execution range) was scrapped in mid-August. TER is the price band within which contracts can trade. The execution range led to trade disturbances in the derivative segment, particularly when there is a huge swing when the market opens. The reference price and range calculated by the NSE were far from the actual price swing.

Following this, NSE removed the restrictions to allow demand and supply to determine the price at which trade gets executed. However, this led to a sudden rise and fall in prices triggering the stop loss set by gullible investors.