Explained | What are freak trades and how you can protect your investment against them

Recently, the futures and options (F&O) segment of the Indian markets has seen a rising number of what has been defined as "freak trades", wherein participants have reported trades being executed far away from the current market price in F&O contracts.

"On Tuesday, as per information provided by Stock exchange, futures contracts of TCS, Bharti Airtel, HDFC twins – HDFC & HDFC bank - recorded an exponential jump of around 10 percent each for a few nanoseconds in early trading hours," said Aprajita Saxena, Research analyst, Trustline securities.

On Tuesday, the future contract prices of HDFC reached a level of Rs 3,135 even as the spot price was hovering around Rs 2,850 apiece.

"Such freak trades are possibly occurring on account of low liquidity caused by new stringent margin norms of SEBI that have increased the capital requirement for traders/speculators. Thus, drying up most of the liquidity from the futures market ecosystem," she added.

Another reason could be, since august 16, 2021, the National Stock Exchange of India (NSE) has completely discarded execution ranges, price bands within which contracts can trade.

Prior to this, the NSE used Trade Execution Range (TER) mechanism as a risk management measure which ensured that market orders didn’t execute beyond a defined execution range.

"This system was avoided because when prices of underlying securities swing dramatically, it created a barrier to price discovery," said Ashis Biswas, Head of Technical Research at CapitalVia Global Research.

This change of stance puts the exchange in line with practices that are followed by other exchanges around the world, which is not to have such restrictions and allow demand and supply at any given time to determine at what price a trade gets executed.

"Their (NSE) stance seems to be that traders have to be careful about this while placing orders on the exchange and that contracts being completely banned from trading for a few minutes is a lot worse than a few freak trades," noted Nithin Kamath, the founder and CEO of Zerodha, in a recent blog post.

According to him, these freak trades can be avoided by placing a limit order.

A limit order is a type of order to purchase or sell a security at a specified price or better. For buy limit orders, the order will be executed only at the limit price or a lower one, while for sell limit orders, the order will be executed only at the limit price or a higher one. This stipulation allows traders to better control the prices they trade.

"Assume that an Index call option contract is trading at Rs 100, and you decide to buy five lots at market price. Instead of placing a market order, you can place a limit buy order at Rs 102. This will ensure that your order is treated as a market order and that the impact cost does not exceed 2 points, if at all," Kamath explained.

"Similarly, if you want to sell at the market price of Rs 100, place a limit selling order at say Rs 98 to ensure impact cost is not more than 2 points on the trade."

Another risk arising from these freak trades is the stop-loss getting triggered.

"If you had bought an Index call option at Rs 80 and stop-loss at Rs 70, a freak trade at Rs 50 would trigger your stop-loss order."

How do you avoid it? Use stop-loss limit orders and not stop-loss market orders, says Kamath.

Unlike the regular stop-loss orders, a stop-loss limit order allows traders to specify a limit on the price at which they will execute. There are then two prices specified in a stop-limit order: the stop price, which will convert the order to a sell order, and the limit price. Instead of the order becoming a market order to sell, the sell order becomes a limit order that will only execute at the limit price (or better).

Saxena also recommends using the stop-loss limit system apart from setting up alert tools/notifications in the trading terminal to avoid such freak trades.