When a market is lock limit up or down, traders are not able to trade the flat priced futures contract. That doesn’t mean the contract does not have a price or can’t be traded; it just means you can trade it in the flat priced market. Of all my years as a broker, it is very rare to not to be able to get a client out of a position in a limit up or limit down market the same day as the limit move via the futures spread or options market.
Let’s take corn for example. The USDA comes out with a January WASDE and Stocks report that is very bullish on the old crop but does not have anything to do with the new crop. March Corn (old crop) settled at $4.50 the day before, and on the news of the report, the market immediately went to $4.90 and stopped trading, as the daily limit for corn is 40 cents ($4.50 + $0.40 = $4.90).
Let’s say you were short corn going into the report and you can’t get out. To liquidate, you have to buy back March Corn but we are lock limit up. You call your broker and ask what you can do. You broker says the market is trading synthetically at $5.00 and can get you out at that price, give or take a penny, right now. How is that possible?
There are two ways to do this. One way is in the options market; another way is with futures spreads. This article will focus on how to trade Lock Limit Markets with futures spreads. Check out my article, Trading Lock Limit Markets with Options, for a further explanation on using options. Remember that the price limit restrictions are only for flat priced futures listed on the exchange. While March Corn is lock limit up in the flat priced futures market, it is trading synthetically in the futures spreads, options and OTC markets.
Let’s get back to our example. March Corn opened at $4.50 and is limit up at $4.90. You call your broker and he says we are currently at $5.00. First, let’s figure out how the broker knows the current price for March corn.
Step One: Find a corn contract that is not limit up. If this USDA report was bullish old crop and did not comment on new crop, chances are May, July and maybe September are limit up along with March as they are all the same crop year. December is new crop. In this example, December opened at $5.00 is up 20 cents to $5.20 on the day, only half of the limit move.
Step Two: Find the futures spread market with the contract you are stuck (March Corn) in and the contract that is not limit up (Dec Corn). The March/Dec spread is trading at -20’0 cents. That means March is trading 20 cents less than December Corn.
Step Three: Add the Contract that is still trading freely (Dec Corn) and the Futures Spread (March/Dec Corn). $5.20 + -0.20 = $5.00. If March corn is trading 20 cents under Dec Corn, and Dec Corn is trading freely at $5.20, then March Corn has to be worth $5.00
Step Four: You are short March Corn and you want to exit. You buy the March/Dec Futures Spread at -20’0 cents. Your short march corn and long march corn (first leg of the March/Dec spread) cancel out, leaving you flat corn and only short Dec. Dec is trading freely and you exit the flat priced Dec Corn contract. Congratulations – you just traded out of a limit up short position!
While many of my clients understand how to get out or into a limit market, they will usually have me do it, even if they are online traders. I actually prefer to do it for them, regardless if they are broker-assisted or online traders, because during a limit move market, you really need to know what you are doing and not make any mistakes.
One extremely important note is to make sure your platform/broker has access to the futures spread markets. Many online platforms will just subtract contracts to form a spread or only allow traders to leg in. This will not allow you to exit your position. You have to be able to access the futures spread markets for this to work. Our dt Pro and dt Vantage platforms both have access to the futures spread markets.
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