Understanding Limit Moves in Futures

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 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 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, with the exception being the Stock Indexes. They only have Limits to the downside and none on the upside. Limits are set by the Futures Exchanges that the products are traded on.

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. If the market goes to Limit and actually closes, there then it is called Locked Limit and expanded Limits go in place for the next trading day. If the market just trades at Limit during the trading day, but does not close Limit, then there are no expanded Limits the next day.

For example, Corn has an initial 30 cent Limit move per day. If yesterday's closing price of Corn was 3.60 then for today's trading Corn could only trade as high as 3.90 (3.60 + .30) or low as 3.30 (3.60 - .30).

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 3.90), then the exchange will expand the Limits the following day to 45 cents. The next day's Limits for Corn would then be a high of 4.35 and a low of 3.45, always adding and subtracting the Limits from the previous day's closing price.

If the market closes Locked Limit up again (4.35) after the expanded Limits, the exchange will again expand the Limits to 70 cents, making the next day's Limit high 5.05 and the Limit low 3.65. Once the market does not close at a Limit high or low, then the initial Limit (30 cents) goes back into effect.

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 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.

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

• Soybean Complex (Soybeans, Bean Meal, Bean Oil)

• Grains (Corn, Wheat, Oats)

• Livestock (Live Cattle, Lean Hogs, Pork Bellies)

• Lumber

• Orange Juice

• Stock Indexes

This is not a complete list. Please visit exchange websites.

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 Limits 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 when price gets near a Limit move that once a close by protective stop is hit, it never gets executed. The market literally just gaps into the Limit 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 stays there into the close. This is because it takes excessive Supply or Demand to drive a market to these Limits. The feeling is that the next day the price will gap in the direction of the Limit due to this pent-up Supply/Demand imbalance. Most traders are not going to exit their winning positions until the next day, 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 day.

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. 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. This is not an impossible event; this happens frequently. Each penny in Corn is $50.

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 $6,250 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 on what to do.

I have been trading Commodity Futures for 22 years and I can tell you that they are the most challenging and rewarding endeavors you will ever undertake. With so much leverage and the many events happening every day, you need exceptional risk management while trading Futures.

"We must get good at one of two things: Planting in the spring or begging in the fall." Jim Rohn