Locked Limit? Here's How to Protect Yourself

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.