Limit Moves in Futures Trading

The soybean futures market went limit-up at the open on Friday (29 June, 2007).

Limit days are one of the reasons I prefer day-trading to other trading styles where positions are held for days or weeks. Imagine you had been long when the market closed on Thursday. Then you would be delighted with the action on Friday, sitting on a large windfall profit!

But imagine for an awful moment that you were short on Thursday close with a stop placed 5 points above the close. When the market opened on Friday your stop would have been triggered, but if the stop order was actioned at all it would have been at around 50 points above the previous close! That is an instance of the market gapping through your stop loss and inflicting far greater losses than you had anticipated – ten times more in this case.

But that is not the half of it! More than likely, the stop order would not execute because under the rules for trading this contract, the market was locked limit up (50 points) for much of the session and trading was suspended. Fortunately, on this occasion, price pulled back late in the session allowing trading to recommence, so your stop would have executed before the end of the day. But imagine how you would feel if the market remained limit up into the close. You would endure a miserable weekend wondering if Monday would be another limit up day, costing you another 50 points with no way to exit your trade. Indeed, it is possible to have a run of several limit days in succession, with disastrous consequences for your account.

Of course, markets can gap through stop loss points when day-trading as well, but it is much rarer than when you hold positions over night or across weekends. The day-trader always closes outstanding positions before the end of the primary session, so is not nearly so exposed to dramatic moves through stop loss points.

Is there anything you can do about limit days? The best defence is to protect your position with futures options instead of normal stops. For example, when you go short soybeans at, say, 840 you may be able to purchase the 840 futures call option for, say, 18 points ($900). If you choose to execute this option, you are granted a long futures contract at 840 points. This means that no matter how high the market goes, you cannot lose more than 18 points (because your 840 short is offset by the 840 long, so your only exposure is the 18 point premium).

This insurance will cost you, of course, because if you exit your short position at, say, 820 for a 20 point profit, you will find that the price you get for your 840 futures call will be much less than you paid. If you can get 6 points for it, you have made 20 points on your short futures position, but lost 12 points on your long call position, giving a net profit of 8 points. For the longer term trader, this may be less significant. For instance, if the market declines over a few weeks to 700 giving you a 140 point profit, your futures call option will almost certainly have lost the full 18 points of value, but this still leaves you a full 122 point profit and lets you sleep easy through events like limit up days.

Even if you decide against using options in your normal trading strategy, they might still save your bacon in an emergency. When the US experienced the first discovery of Mad Cow Disease the futures market for live cattle went limit down for several days. This was in a period where there had been a sustained up-trend in cattle prices, so many traders were caught in long positions. The thing to remember is that when the futures market goes limit up or down, trading is suspended in futures contracts but not in futures options. Therefore, when the live cattle went limit down, it was still possible to buy futures put options which would serve to protect against further major declines. The problem with this is that the put option premiums are sky high in this scenario, so you will still incur a very substantial loss. Still, if you want to get out at all costs and the futures market is locked, this is the way to do it.

The other thing to notice from this discussion is the importance of trading small. If you are trading too many contracts and get caught on the wrong side of a limit move, you can be wiped out in a flash. That is why professional traders limit planned exposures (their planned stop loss points) to less than 2.5% of their overall account. Even if a disaster occurs, and they suffer a loss 10 times greater than they planned for, they are still in the game. Anybody risking more than 4 or 5% is likely to be dealt a blow from which they cannot recover, and anybody risking 10% or more is dead in the water.

A further consideration is that limit moves following sudden bad news are often over reactions. If your position is small relative to your account size, you will have the capacity to ride out the storm, and exit at much better prices when the first panic recedes and prices retrace towards former levels. Traders carrying too much risk will not be able to do this because they will suffer margin calls and be forced to exit contracts at the worst possible time.

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