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 options market.
Let’s take corn for example. You are short corn from $4.50 and 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 settled at $4.50 the day before (the price you sold march corn), 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, with a 50 cents loss (you are short from $4.50) 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 options. Check out my article, Trading Lock Limit Markets with Futures Spreads, for a further explanation on using futures spreads. 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 where the price is.
Step One: You are short March Corn from $4.50. You want to buy March Corn to get flat. The first thing you have to do is look for deep in the money March Corn option prices. I typically look at the $1.00 calls.
Step Two: Your broker calls the floor and gets a market for the $1.00 corn calls. You will most likely have to use a floor broker as there may not be a market for those calls on the screen. Your broker gets the market for the $1.00 March corn calls and they are going for $4.00 ($1.00 Call + $4.00 Premium = $5.00 for March Corn).
Step Three: You buy the $1.00 March Corn Call for $4.00. This call is so far deep in the money that the exchange will convert the option into a futures position later that night. If they don’t, your broker can make the request option exercises to futures.
Step Four: You are short March Corn from $4.50. The exchange converts the $1.00 call to a long futures contract from $1.00. The existing short March Corn and the new long March Corn offset. The gain on the futures trade is $3.50 ($4.50 short – $1.00 long). The loss on the options trade is $4.00, the premium paid. The net loss is $0.50 cents (+$3.50 – $4.00). When your broker told you the market was synthetically trading at $5.00 and could get you out there, the loss from being short from $4.50 would be 50 cents ($5.00 synthetic March corn price – $4.50 your original short march corn price)
One extremely important note – make sure your broker really understands this process. Even though the option costs $4.00 ($20,000), there is no need to have this amount in your account to buy the option because it is going to automatically offset the futures. Most, if not all, online platform are not equipped to understand how this works, and they would probably require you to have $20,000 per option, which is absurd. The broker gets around this buy executing on the floor and then placing the trade in your account. When the option hits the statements later that night, the option becomes a futures contract, the futures cancel, and all you are left with is the final P&L.
For all of my clients who have ever been in this situation, I prefer to execute the exits for them regardless if the trader is broker-assisted or an online trader. When the markets are making limit moves, it is more important than ever to not make execution errors. Since this type of execution is something I have experience in, I find it best if I take care of it from start to finish for the client. If you would like to know more about how this process works, please feel free to contact me directly.
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A PERSON CONTEMPLATING PURCHASING A DEEP-OUT-OF-THE-MONEY OPTION (THAT IS, AN OPTION WITH A STRIKE PRICE SIGNIFICANTLY ABOVE, IN THE CASE OF A CALL, OR SIGNIFICANTLY BELOW, IN THE CASE OF A PUT, THE CURRENT PRICE OF THE UNDERLYING FUTURES CONTRACT OR UNDERLYING PHYSICAL COMMODITY) SHOULD BE AWARE THAT THE CHANCE OF SUCH AN OPTION BECOMING PROFITABLE IS ORDINARILY REMOTE.
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