Commodities

Trading Around Limit Moves in the Futures Markets

dondawson
Don Dawson
Instructor

Most of us have seen the movie Trading Places. It is the story of a few guys that are trying to corner the Orange Juice market and two traders come in to break up the scheme. During this time they witness the Orange Juice market go Limit up on the monthly Supply and Demand report that was released for the orange crop. Then, almost as fast as the market went Limit up the selling came in and drove the prices to Limit down all in a short order of time. This may have been a scene in the movies, but this has happened in real life markets many times. Note: under no circumstances would I advise trading the Orange Juice contract. This market is dominated by the commercials and has very little liquidity.

A Limit Move is the maximum amount the price of a Commodity Futures contract can change during any particular trading day up or down from the previous day’s closing price. Many years ago the majority of Futures contracts had these daily limit moves. Over the years the Exchanges have removed limit move restrictions on most of the Futures markets and allowed the markets own supply/demand to determine how far the market can trade each session.

The market can trade to these Limits and actually turn and go the other way during the trading day. The limit just restricts the market participants to no buying above the limit high or no selling below the limit low.

For example, Corn has a 25 cent initial limit move per day. If yesterday’s settlement price of Corn was 4.10, then for today’s trading Corn could only trade as high as 4.35 (4.10 + .25) or low as 3.85 (4.10 – .25).

I mentioned initial Limit in a previous paragraph because if the market trades to a limit up and closes there, Locked Limit (above example closes at 4.35), then the Exchange will expand the limit move for the following day to 40 cents. The next day’s limits for Corn would then be a high of 4.75 and a low of 3.95, always adding and subtracting the limits from the previous day’s settlement price. Once the market does not close at a limit high or low then the initial limit (25 cents) goes back into affect.

This is why it is important to know the market you are trading and be aware if it has these limits in place. You can find this information on the contract specification sheet of each Exchange. Usually it is listed under “Daily Price Limit.” Here is a link to the Corn contract specifications on the CMEGroup website, www.cmegroup.com/trading/commodities/grain-and-oilseed/corn_contract_specifications.html.

Not all Commodity Futures have limits. Several years ago more markets had these limits, but some have since been removed. The reasons for these limits are to allow calmer heads to prevail. Usually when a market goes limit up or limit down there is an event that triggered it. Sometimes it is weather related, supply/demand Report or just excessive fear or greed in the markets. The Exchanges feel that if they stop the trading then people will have time to analyze the situation and perhaps see that there was simply an overreaction to the event that started the move. There are mixed opinions about how effective these Limits are. Some say that it restricts the process of price discovery and puts artificial barriers in the market place. Others say that it helps to protect traders/investors from being wiped out by excessive price moves.

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Here are a few of the markets that currently do have daily price limits:

  • Soybean Complex (Soybeans, Soybean Meal, Soybean Oil)
  • Grains (Corn, Wheat, Oats)
  • Livestock (Live Cattle, Lean Hogs, Feeder Cattle)
  • Lumber
  • Orange Juice
  • Cotton

You should always have a protective stop in the market when you trade, but when trading these markets with limits it would be financial suicide not having protection in the market. A trader must be careful when trading in markets with limit moves regarding their protective stop placement. Keep in mind that a protective stop becomes a market order once your stop price is traded at. The mistake people make is placing a protective stop too close to a limit move. There is usually so much fear in the market when price gets near a limit move that once a nearby protective stop is hit there is a good chance it will not be executed. The market literally just gaps into the limit move and trading stops. This leaves you stranded in a position unless the market comes off limit. Most of the time a market that goes limit up or down stays there into the close. This is because it takes excessive Supply or Demand to drive a market to these limit moves. The feeling is that the next trading session the price will gap in the direction of the limit move due to this pent up Supply/Demand imbalance. Most traders are not going to exit their winning positions until the next trading session, most likely on the gap open. If the market goes limit up and you are short (sold) the market, then you have no way of exiting that position until the next trading session.

This is where the horror stories come from in the markets. Due to that pent up Supply/Demand imbalance that caused the market to go Locked Limit, the next day’s open can actually gap in that direction right into a limit move and again you will be forced to stay in that trade. Each day you will continue to lose money and you will not be able to exit until the market comes off that limit. Some Commodity markets have been known to go limit for 4-5 days at a time. This is not an impossible event. These extended daily limit moves were more common before electronic and longer trader sessions. However, the Lean Hog contract had such an event in 2014.

I am going to give you an example of how expensive this could be if you get stuck in this type of situation. Let’s assume you shorted (sold) Corn at 3.80 and it went Locked Limit that day and you could not get out. In this example we will say you got caught in a limit move for 3 days. Each penny in Corn is $50.

Position

Closing Price

Limits

Equity loss

Day 1

Short @ 3.80

3.90 limit up

.25 from previous settlement price

$500.00

Day 2

Short @ 3.80

4.30

40 cents

$2,500

Day 3

Short @ 3.80

4.70

40 cents

$4,500

In this example, your short position from 3.80 got caught in a Locked Limit move and each proceeding day the market gapped into another limit move forcing you to stay with your trade until Day 3, when the market finally came off limit and allowed you to exit with a $4,500 loss per contract.

I am not showing you this to scare you from trading the Commodity markets, but I want you to be aware of the risk in these markets if you don’t do your homework on the markets you are going to trade.

There are some ways to help protect yourself if you find yourself in these situations, but you have to act fast because everybody else is going to be looking for these “insurance policies” also.

  • You can use an Option to protect yourself if you get caught. If you are short the Futures then look to buy a Call Option to protect you from more upside losses. If you are long the Futures then look to purchase a Put Option to protect you from further downside losses.
  • Futures contracts always have other contract months trading at the same time. In the Corn example, if you were short the March contract you could “spread” your position by buying a May, July, September or December contract. This way you are locking in the difference between your original entry price and the new contract you bought. This way if the market opens limit the next day and all the contracts go limit then the difference between the two prices has not changed.

When you decide to trade Commodity Futures you must be prepared for these unexpected events to happen and have something in your trading plan describing how you will handle the event. Do not wait until this happens and you have to make an emotional decision of what to do.

“Success is walking from failure to failure with no loss of enthusiasm,” Winston Churchill.

Don Dawson

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.