Few phrases can make or break a commodity trader’s day more than “limit up” or “limit down.” On the right side of a limit move, a trader can potentially reap significant and rapid rewards. On the wrong side of a limit move, a trader can see their account go up in smoke, or worse, go negative.
A limit move is when the supply/demand balance becomes heavily tilted to one side, and buying overwhelms selling or selling overwhelms buying.
Many markets have daily trading limits put in place by the exchange on which they are traded. These daily limits are designed to keep markets orderly and to try to prevent massive amounts of market participants from being wiped out in a single day.
A market can go limit up or limit down and then come off of the limit. Markets can even go limit up, reverse, and go limit down all in the same day. If a market closes up or down the limit, the price limit will be extended the next day. If the market is locked limit the next day (meaning prices are still moving up or down the limit), then price limits may be extended again the following day.
If you are caught on the wrong side of a limit move, you may have to turn to the options market to try to control the damage.
Take a look at this example:
You sold one contract of May corn at $3.80 per bushel at the open. As the morning session progresses, corn rises until it reaches the daily price limit of $4.10 per bushel. At this point, the market has gone limit up, and you are not able to exit the position as there are no willing sellers. You are stuck, and the market appears to be pricing in corn at $4.50 per bushel.
The market may remain locked limit the following day, and with an expanded price limit of say $.40, the market could open all the way up at $4.50. Needless to say, this would represent additional significant losses on your short position.
In such a scenario, you may potentially be able to offset some risk by purchasing an option. In this example, if you are stuck short corn, you could look to purchase a call option that could gain in value as prices rise. You will likely have to pay up for such an option, however, as volatility and call demand could cause premiums to rise swiftly and severely.
Another option could be to take an opposite position in another contract month. In the above example, if you are caught short in May corn, you could look to buy July corn. If May goes limit up again, the July contract could potentially rise or go limit up as well.
Limit moves can be both exhilarating and downright scary. Always trade with stops and realize that such moves can and do happen. If you catch such a move, great. If you get caught by such a move, try to keep a cool head and look at your options as quickly as possible for hedging additional potential losses.
