The Magic of Trading in Limit Markets

When futures are limit-bid or limit-offered, with unfilled orders at the limit price, trade can continue synthetically — at a value beyond the limit price by using spreads or options to create a synthetic strategy.

— Using spreads and the “no limit” spot month to “bypass” the limits on deferred futures. July corn futures were off 75 or more on June 30. But most people who wanted to sell September futures at 30 lower were unable to fill their orders; there were far more offers than bids at limit down. But you could sell July ’11 futures. The next step (immediately or later) was to enter a spread order and buy back the July position and simultaneously sell September futures to “move” the futures sale to the September contract month. Interestingly, the July/Sept spread on June 30 was only minimally changed from the prior day, trading around 22 inverse at times before closing at 28 inverse. (See Example 1)

The key in this example is that spreads can continue to trade even when all futures are locked limit up or down, and they can trade independently of values indicated by simply subtracting one price from another. Example: On 6/30, $6.25 July minus $6.48 (limit down in Sept futures) made it appear the spread was a carry of 23 when in reality the spread was still trading at a 22 inverse. It’s important to first verify the current bid/offer on the spread.

In this example, an elevator could sell and hedge farm purchases in September futures indirectly, and bypass the “brick wall” of the price limit. Conversely, an end user that wanted to buy corn for feed could have bought September futures at limit-down, $6.48, or taken the extra steps and ended up with a purchase at $6.03, for a gross savings of 45.

— Using spreads to execute orders in a limit market when the front-month still has a daily trading limit. If a limit bid or limit down market develops while the front contract month still has a price limit, there may still be a way to execute orders. Not all futures months may go limit sellers or limit bid immediately, or at any time during the session. This allows a buyer or seller to execute the desired order in a deferred futures month where there’s less “action,” and then spread the trade back to the desired month. As with the prior strategy, be sure to check what the spread bid/offer is to know what price you will net: (See Example 2)

— On days when a limit move is expected, the CBOT will post a previously unlisted option strike price for each futures month, for immediate trading. This will be a deep in the money strike price, which will move essentially as a futures contract would. ($1 September corn call, for example) Buyers can buy the call at whatever price they’re willing to bid and then immediately exercise the option. Buying a $1 call for $5.03/bushel is the same as buying futures at $6.03, and could have occurred even if futures were limit-down at $6.48. Selling a $1 call for $5.03/bushel would yield a short futures equivalent of $6.03 for the option seller, after the call option is exercised by its owner. Because a new Strike Price has no prior settlement price, the premiums can move up or down the daily limit from the first trade price of the day. In all but extreme cases this will create a wide enough range to allow synthetic futures to be created at levels equivalent to beyond the limit price in futures. On June 30, however, the price move was so extreme that the CBOT listed a second new strike price midday to allow the synthetic futures to move even further.

The June 30 collapse showed strengths and weaknesses in the argument about price limits. Daily limits do allow time for buyers and sellers to reassess price goals and strategies, and provide time to prepare for additional margin calls. Prices will still find their “right” value, and the world is surely not harmed if it takes even two or three days to do so instead of instantly. It’s worth noting that after the dramatic drop on June 30, July 11 futures closed 11 higher on July 1, and December 11 futures closed 23 lower. The net for December corn after two sessions was a drop of 53. Within a few hours of the close on June 30, prices had found equilibrium.