Nifty Futures Flash Crash

Nifty futures flash crash
There was huge and abnormal activity in Nifty Futures on 20 April 2012 around 2.40 pm, when it fell from 5338 to 5000, a drop of 7% within few seconds. Later it recovered and settled around 5250/5300.  During this crash the number of contracts traded were 35,000 lots or 17.5 lakh shares.  What could have happened and how can a trader protect himself from such wild swings?

To start with, there could be many possibilities which could have caused this crash.The error could be due to wrong punch or entry of  a sell order with a wrong quantity or price. Another possibility is that it may be due to algorithmic trading or prominently known as Algo trading, which is so programmed, that in case there is a fall below a particular price level, the algo will initiate a sell order no matter what the price is. There was also a similar flash crash in US markets in 2010, when Dowjones crashed about 1000 points in a matter of few seconds.

What does this all mean for a trader? As a trader, if you are long or short, you have to hedge your positions to minimize your risks in trading. One has to be prepared for such kind of  flash crashes or up-freeze market, when markets went up 20% in 2009 post-election results.Any retail trader trading nifty futures or other similar derivative products, must hedge his positions buying puts or selling higher strike price calls. Say, one is long in nifty futures at 5300, it is better to sell 5400 strike calls or buy 5200 puts. There are  many more such strategies which could be used depending upon individual trading positions.

As an investor, such wild swings give you big opportunities. Such crashes provide you an opportunity to buy good stocks for long-term, if they come down 15-20% , for no fundamental reason. As always, if wealth creation over the long term is really your objective, it is better for retail investors to invest in mutual funds and leave the rest to the market.