Abid Hassan
In the last few days, trading volumes have fallen across segments, causing havoc among traders. In this article, we will examine the effects of this, and what precautions we can take to decrease our risks:
1) Wider bid-offer spreads increasing costs
Bid-offer spreads have increased in the futures and options segment. This is lower on liquid contracts of Nifty and Bank Nifty futures, at the money options, and out of the money options.
In the illiquid contracts: in the money strikes and far dated futures and options are affected. Stock options are the worst affected.
How to deal with this:
Trade contracts which you know you will get exit from. Use limit orders instead of market orders. Avoid illiquid stock options, and try to stick to index.
2) Whipsaw takes out stop-losses
Volumes absorb volatility. As volumes are low, the volatility has spiked. This means in the whipsaw happening around supports and resistances, stop losses are getting hit.
How to deal with this:
Reduce the position size. Keep deeper stops that can accommodate the volatility.
3) Higher impact costs for larger orders
If there are 2 offers at 100, 2 stocks can be bought at 100. But, if liquidity is low, one offer is at 100 and another at 101. This makes the price 100.5. This extra 0.5 is the impact cost. Big traders have higher impact costs now
How to deal with this:
Stick to liquid contracts. Use limit orders instead of market orders.
4) Gaps and jumps.
Low liquidity causes gaps and sudden surges. Stop losses can be missed, leading to unlimited losses. An unusually higher number of holidays in India in April exacerbates the effects of this as India catches up with news from the overseas markets which remain open.
How to deal with this:
Systematic stop-loss orders should be kept in the trading terminal. Retail investors can consider moving from futures and naked options selling to risk defined strategies such as option spreads.
5) Illiquid options
Most options have lower liquidity now. We already covered the bid-offer and impact costs. There is a bigger risk specific to options. Exiting options to book profit or loss has become difficult, and traders are getting stuck in positions.
This is especially dangerous in stock options which are delivery-settled, which needs higher capital and costs more.
How to deal with this:
Stick to liquid and cash-settled contracts like an index. Avoid less liquid stock options. Square off stock option positions before expiry.
6) Mispricing in most strikes due to low liquidity
Illiquid options are showing absurd prices, IVs, etc. This leads to incorrect decisions on premiums, break evens, Greeks, etc.
How to deal with this:
Sanity checks any option price you see. Double-check the bid-offer spreads. Stick to liquid options. Avoid illiquid times like the opening hours.
(The author is Co-Founder and CEO at Sensibull)
Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
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