The Magic of Trading in Limit Markets

Limit markets in futures can be frustrating; it’s like running into a brick wall. A “limit-down” day can make it seemingly impossible to sell futures, and merchandisers are often unsure what to bid farmers. “Limit down” means the market has reached its lowest possible price for that session, although there may be active trade at that price. “Locked limit down” means prices have hit the lowest possible value for the day, and there are unfilled sell orders at that price. Trading stalls. This has led to calls for higher limits, or even no daily price limit. But there are ways to continue to buy or sell futures, if you know the ins and outs and how to make magic.

Daily price limits in agricultural futures are an effective “circuit breaker,” providing time for additional order flow to bring some balance to price discovery, and providing some protection against the specter of an uncontrolled free-fall or rally, similar to the now-infamous “Flash Crash” that occurred in the equities sector on May 6, 2010. On that day a mutual fund entered an order to sell 75,000 E-Mini futures contracts to hedge an equity position. The fund used an automated execution algorithm that did as it was instructed, but triggered an unintended broad-based collapse of 15% or more of the value, which just as quickly reversed, and causing some individual stocks to trade as much as 60% lower than just moments before, according to the Commodity Futures Trading Commission and SEC joint report. The break hit and was over before traders could even determine in what market it began, let alone what caused it, but left a trail of confusion, poorly executed orders, and little to no true price discovery. (Note: CME E-Mini futures are an index product equivalent to the S&P Index value times $50.)

The dramatic collapse in corn futures on June 30 was a similar situation after the bearish USDA Stocks and Acreage reports were released that morning. July 2010 corn futures, which had no daily price limit, plummeted 75+ cents — almost a 10% break. That day’s action showed both strengths and weaknesses in the structure of CBOT ag contracts. June 30 happened to be month-end and quarter-end, when speculative and investment funds post their results. The “real” price of most months of corn futures would have been lower than the 30 “limit down” posted settlement, but statements are based on settlement prices. Fund results for June were out of sync as a result, and the pressure is sure to increase in the investment sector for higher daily price limits. The cash grain sector may have had its own challenges determining the right values to use for month-end P&Ls, but grain firms are largely on the side of maintaining price limits.

Market purists were enraged on June 30 because corn could not be sold in deferred futures, but could be priced synthetically via options or using the spot July futures contract. A mini-refresher on CBOT rules and procedures may clarify how to execute these trades. (The same procedures apply on KCBT and MGEX wheat contracts.)

• Effective on the second business day prior to the first business of the front-month futures, the daily price limit is removed for the spot contract month. As of June 29, July 2011 grain/soy futures no longer had a price limit.
• Options have a daily price limit that matches the daily price limit on futures. Corn options have a 30 limit, for example; 70 for soybeans and 60 for wheat.
• A newly listed option strike price has no prior settlement price. A new strike price will be subject to the same daily limit, but the “first tick” can find its own level, with all trades after that subject to the daily price limit
• Futures spreads have a daily price limit that is double the limit on the outright futures. The limit on corn futures is 30 up or down; the limit on spreads on corn futures is 60 up or down.
• Futures spreads can continue to trade freely even when the individual futures months are both limit up (or down).