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Saturday, April 21, 2012

Freak Trades or Flash Crash on NSE: What is it and Why?

With the complete automation of Stock Exchanges and 100% computerization of markets, there comes a added risk in form of large, unexpected Freak trades which often crashes a specific Stock, or group of Stocks or even Index for a short while, thus causing tremendous loss to market participants and dampening  the sentiments, not to mention damaging the faith of common man in stock markets.

Freak trades or Flash crash or Fat-finger trade, whatever the name we prefer to give them, can be either due to human error or computer algorithm failure in nature. There have been instances on Dow Jones, where the world’s most powerful index crashed by over 10% or over 1000 points on an intra-day basis and caused huge public uproar and damage in sentiment. Often some of these trades are reversed or cancelled by market regulators, but the sentiment damage is done by then.

In our local markets, at BSE and NSE, most of the freak trades are human errors in nature as level of computer algorithm generated trade is still less when compared to NASDAQ. At NASDAQ, for example, about 80% of trade is carried out by algorithms and in an automated fashion and the comparative figure is about 60% for NYSE stock exchange. For NSE, automated trading is still below radar, probably still below 20% of total volume, however it’s definitely growing as FIIs play a bigger role in our markets.

Some examples of so called Freak trades in BSE are human errors in nature. Traders while entering large quantities of order sometimes make a mistake while punching in trade price or quantity or miss mentioning stop-loss or similar grave errors and if the quantity is large and price way apart from last trading price, it will create a tremendous spike in stock price for a short term. Is it intentionally done or is it profitable for trader or dealer who is entering these trades? Not so, often these traders lose tremendous amount of money due to these freak trades which run into Crores of damage in just few seconds.

Examples of such trades on BSE are many. For example, on June 1, 2010, the stock price of Reliance Industries (RIL) crashed by around 20%, and this crashed Sensex and Nifty down by several percentage points for some minutes. In this session, RIL was trading at around Rs 1,030 level, when suddenly the price crashed by about Rs 190 to Rs 840.55. It was actually an order entry error by a trader trading for a European company who mistakenly sold 62,000 RIL stocks in what was meant to be an order for ICICI Bank stock. 

This trader and its firm suffered huge losses and some traders on other side of trade would have made unexpected windfall gains. Remember, often when someone loses money in Markets, it is someone at other end of the trade who is making a windfall gain. But loss in sentiment and public faith in markets cannot be undone.

Similarly, yesterday on NSE, some traders sold Infosys stock and Nifty index derivatives without a stop-loss or price limits and this crashed and spooked the whole market for quite some time. In the first session on 20th April, 2012, Infosys stock futures were trading above the Rs 2,400 level and suddenly crashed nearly 20% to Rs 1,950.

On the same day, just a few hours later, the Nifty futures crashed 6.7% when a large number of contracts were sold at 5,000 levels. About 35,200 nifty contracts (each contract equals 50 Nifty shares) were sold within one minute at 5000 levels when the actual trading price for Nifty was hovering at around 5350. The marked nose dived due to this error. The trader executing this trade suffered about INR 10 crores of loss within few minutes, but market sentiment was dampened and indexes closed lower even though they had recovered within a few seconds of this freak trade. Pl see the chart below for what actually transpired.

In the case of DOW flash crash, the algorithms doing automated trading went haywire and on May 6, 2010 Dow Jones Index dropped by 998.5 points on an intraday basis. The official report released explained that the crash was caused by the use of an automated “Sell Algorithm” selling $4.1 billion of stock index futures by a single firm. 75,000 E-mini derivative contracts were sold in 20 minutes on DOW, which caused the flash crash.

Whether, automated or manual, flash crash or freak trades, is a cause of grave concern for the common investor and regulators should do whatever its best, whether to regulate automation or put circuit breakers and filters in place to check the order size and price before it hits the markets and causes tremendous damage to the participants.

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