Locked Limit? Here’s How to Protect Yourself

Risk is an intrinsic feature of futures markets, and traders who learn to keep
a short rein on risk become the most successful traders. A trader’s goal should
be to become a risk hawk in order to keep losses small and let profits run.
Before every trade, I ask “what can go wrong, how can I lose, and how can I
protect my downside in the event of a large, adverse move?”

Markets are intrinsically unpredictable and have the propensity to do the
unexpected. Many markets place limits on extreme moves that halt trading beyond
a certain point value. These are called limit moves and are established by the
futures exchanges. In limit-locked futures markets, trading is halted and
no trades are permitted beyond a certain level. In some instances of an adverse
move, a market can blow through your protective stop without filling your
offsetting position and can leave you vulnerable to further downside. A market
may then proceed to make a limit move again and perhaps continue to do so for
several more days.

While multiple limit-move days are rare, they do occur. Having a strategy for
dealing with this extreme and expensive situation should be a part of every
trader’s risk management arsenal. This article outlines the major strategies for
containing losses in limit-locked futures markets. Your objective will be to
lock in a loss and prevent further erosion of capital.

Spread It Out

One approach to neutralizing loss in a limit-move situation is to trade a
spread in the same commodity in a back month that is not limit-locked to achieve
an offset. For example, if you are short March cotton and the market has locked
its 3-cent limit against you, but the October contract is still trading because
it is not locked, you can buy a March/October spread. In this spread trade, you
buy the March contract and sell the October contract. After you have established
the spread, you then buy back the October cotton, effectively offsetting
your March position. You should be able to initiate a spread in any locked
market this way. The spreads will generally be more expensive then the limit
down level, but the additional cost is usually worth the risk of getting stuck
in a second, or in multiple, locked-limit days.

You can also just take the opposite position in a back month that is not
locked, creating a spread. This can help limit, although not perfectly offset,
additional downside risk. Also, a spread may not work in the manner expected. In
agriculture markets, for instance, be careful of different crop years, which
might not be correlated with the market you are locked up in and may be
responding to totally different fundamental conditions.

Using Options To Lock In A Loss

If an underlying futures is locked but options in the futures are not locked,
you can create a synthetic position for the futures in the options
market. A synthetic is a combination position that has the same value in terms
of gain as the underlying futures and is used in a limit up or limit down market
to lock in a loss.

Say you are short New York crude oil futures and are caught in a limit up
move (a move greater than 1.50 per barrel). You can create a position that,
although it will not shield you from the limit move that has already occurred,
will offset any further loss. You create a synthetic
long position
by buying a call option and selling a put option at the same
strike price. Conversely, if you are long crude oil in a limit down situation,
you can neutralize any further loss by simultaneously buying a put option and
selling a call option at the same strike price to create a synthetic
short position.

Options have limit-locked levels as well. Although you may not be able to
create a synthetic at the exact price (at-the-money or in-the-money) of the
limit level, you should be able to create a synthetic position slightly
out-of-the-money. As Art Liming, Senior Broker at Lind-Plus described, “You
find out your options quotes at different strikes and then compare the prices to
determine how much of the risk you want to take away.” In more liquid
markets you will get better fills than in less liquid markets. For example, you
are more likely to get a better price for soybeans options that are limit-locked
than lean hogs options.

As these straightforward strategies show, the consequences of locked futures
markets are not the end of the world. But as with every good risk management
plan and every good (risk-hawkish) trade, begin by preparing for the worst-case
scenario.