One of the first decisions a trader needs to make is whether to open a separate error account. While every effort should be made to have check and double-check entries before hitting the trade button, at some point you will have an error. When that happens, just remember the opening words of The Hitchhiker’s Guide to the Galaxy — “Don’t panic.”
As long as there has been trading there have been trading errors. Back in the open outcry days, orders went from the customer to the broker to the order desk to the floor desk to the runner to the executing broker and back again, and errors were common. Once an error was discovered, and if the market was still open, it was the job of the order desk to just get out of the error and then determine fault. Determining fault was usually easy. There were double-checks in the system, composed primarily of duplicate orders and telephone recordings, that would tell the story. If it was determined that the customer, broker-agent or floor broker was at fault, they ate the error. If the error occurred at any other point in the process, the clearing firm swallowed the loss and then played the tapes to see just who wasn’t going to be getting a Christmas bonus that year.
Of course, that is assuming that the error resulted in a loss. Sometimes errors produced winners and the rule of thumb was that whoever was going to eat a loss should reap the unintended benefits of their incompetency. It was my experience, however, that customers seldom reported errors in their favor.
Every person or entity along that chain had to maintain an error account for both practical and legal reasons. But in today’s world of trading where independent traders execute their own order entry, if there is a mistake in your account, it’s probably yours. And if you are just trading for yourself, there are no legal or tax reasons to maintain an error account, so why have one?
The most compelling reason for a trader to do so would be to segregate errors in execution from the performance of any trading system or program he or she is utilizing. A large error — in either direction — can create a false picture of system performance and cause you either to maintain a losing strategy or attempt to fix something that is not broken. The second reason would be to keep track of errors. A growing error account is a red flag telling any trader to pay more attention to the job at hand, or that additional checks must be built into his execution. Self-discipline is an important part of the makeup of any successful trader and concentration on order execution and position tracking is an obvious test of this trait. A third reason would be if the trader wants to turn his trading into a business where he takes on outside investors. It always is best to show the true performance of the trading approach and that you actively monitor and control errors.
Independent traders are, in effect, small businesses. Anyone who runs a successful small business knows they have to control costs. Errors in a trading business are like spoilage in the restaurant business: Unnecessary costs that could be minimized through more diligent monitoring.
It is acceptable, although not always easy, to set up an independent error account. As long as both your trading account and error account are registered in the same name and social security number and are with the same clearing firm, you can move trades from one account to another. Of course, you could avoid the hassles of an error account and accomplish much the same by logging your trading and errors separately in the right spread sheet software.
So how would an error account work? Let’s say on Friday, Dec. 30, 2011 a trader was short 10 March 2012 S&P 500 futures contracts from 1260.00 and wanted to cover that short at 1255.00. The only problem is our hypothetical trader hit one too many zeroes and bought 100 instead. If our trader sold out the extra 90 contracts at 1254.00, he could then put those in his error account along with the extra 90 contracts from the first order. “The cost of trading” (above) shows the price tag of this blunder. That trader’s trading account would show a trading profit of $12,500. However, the sloppiness in execution cost him $10,000. This trader needs to work on creating safeguards. If he has a common order size, say 10 contracts, that would be locked in and he should not need to enter size for each order and risk a fat-fingered error. And, there always should be a maximum order size. It also is an extreme example. Even with an avoidable fat-fingered mistake, he should have been able to get out immediately with a couple-of-tick loss instead of a full point, and managed to salvage some of the profit.
What is and isn’t an error
This is probably a good time to discuss what constitutes an error. If you were the trader in the previous example and you were looking to cover your short at 1255 in the March contract (SPH) but didn’t pull the trigger and instead the SPH rallied to 1256 and you got out there, you didn’t make an error — you made a trading mistake. Mistakes are also a question of a lack of self-discipline. Good traders log their mistakes and study them, but mistakes are not errors. Errors best can be defined as the discrepancy between intent and execution. Conversely, if you intended to buy 10 SPH at 1255 but instead bought 10 June (SPM), you made an error.
What are the most common types of errors? Every order, whether transmitted to a broker or self-executed, is a call to action (buy or sell) of a certain type (market order, price order, stop, etc.) that might contain the name of instrument, a price and an expiration month. Any of these can be entered incorrectly.
The most dangerous can be a buy vs. sell or vice-versa. If you tried to cover those same short 10 SPH from 1260, but if instead of buying 10 at 1255 you sold 10 at 1255, you are now short 20 contracts. If it rallies to 1256 and you buy 20, you have trimmed your profits by 40%. Instead of a $12,500 profit by buying at 1255, you have covered your short at 1256 which is only a $10,000 winner (see “The cost of trading”). Plus, you have to subtract the $2,500 you lost by selling 10 SPH at 1255 and covering at 1256. Now you only have $7,500, which is only 60% of $12,500. The important thing to remember about buy vs. sell errors is that if you accidently sold 10, you now have to buy 20 — do double the opposite of whatever you did wrong. This is a common question on broker tests.
If you enter a price incorrectly and an order that, by intent, should not have been filled was filled, you can cover the trade and put it in your error account and then re-enter the order with the correct price for your trading account. The same would apply for a stop order that was not intended to be set off. If an order should have been filled and wasn’t because of incorrect information, you have to make the decision as to whether or not it’s worth it to jump back in. Un-canceled orders also can come back to haunt you. If you cover a long position by selling for a profit, you might see that profit vanish if you forget to cancel your sell stop and get touched off on the low of the day. Most front-end systems offer multiple alerts to prevent these types of errors so you should take advantage of them. Again, if an order is unintentionally executed, the best thing to do is to just get out fast. Typically you will lose only a tick, but if you try and scratch it or work the error, you can have a small problem turn into a big one.
If you are trading options or futures, one the most common errors is executing the right trade in the wrong month. In cases like these, it usually is better to spread out of your error. If you intended to buy 10 March S&Ps but bought 10 June, your June position is going to go up or down along with your intended March position. You have, in effect, put on a short-March, long-June spread because you need to buy March and sell June to get to your intended position. If you tried to sell your June S&Ps, you would be trading in a much thinner market than March, and then you have to jump to March and buy them before you get caught in the switches. The solution is to enter a spread buying 10 March and selling 10 June S&Ps. While the outright S&P contracts can be extremely volatile, the intra-market spread usually is quite stable over a short period of time and you likely would not lose anything other than the additional commission and perhaps one tick. You also can request specific prices on your spread, creating a scratch on the error.
The main rule of thumb on errors in the old floor days was to just get out: Establish the error, cover it, determine whose fault it was and move on. Options traders dealt with errors a little differently. Because there are more choices in options trading, there are more choices in dealing with errors. There also is a greater chance for errors because there are more factors in an options trade. For example, you can have buy vs. sell in options, puts vs. calls and dozens of strike prices.
To give you an idea of how you might get out of an options error, consider this example: You have accidentally bought 10 AAPL January 405 puts at 4.00. By the time you catch the error, the bid for those puts is 3.90 but you still can sell the January 400 puts at 2.00. If you sold 10 of those you have bought the AAPL January 405-400 put spread for $2.00. If AAPL goes down you could see a return as high as $3.00. (405 – 400 = 5 (maximum value) – 2 (cost). If AAPL goes higher, you can’t lose more than $2.00. Options traders tend to think that way; turn an accidental outright position with naked exposure into a well-valued, protected spread.
The best way to catch errors is to check your position diligently before and after every trade execution. Make it a habit — remember self-discipline and use all the software tools at your finger-tips to avoid them. If your position or your money is off, find the error and get out as best you can and move on. Of course, the best advice is to not make errors in the first place. If establishing an error account helps you get to that place, then go for it. Ideally, if you put your errors in an error account or just track them separately from trading performance, you, like most traders, will learn the importance of avoiding them altogether. Most important is to have a plan and not to panic.
PJ McCarthy was a floor manager at the CME and an independent trader at the CME and CBOT. He currently is managing partner of The Chicago School of Trading. He can be reached at firstname.lastname@example.org.