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What is a limit move? It is the maximum allowed price deviation from the previous day close price.
Limit moves are an instrument of protection of markets and traders, who find themselves on the wrong side of trade. Their use has its reasons, especially in markets where traders can use the Leverage. Profits and losses of such traders are significantly higher than if they only used their own funds.
By setting price limits, exchange intends to avoid unwanted price movements, possible manipulation and excessive price volatility, especially during a sudden outbreak of panic in the market. Rules for setting the limit moves are determined by the Exchange. The maximum allowed tomorrow's limit move is calculated from today's close price.
Example:
- Close price for Corn is 400 cents per bushel.
- Limit move for the next day is set by the Exchange at:
400 - 30 cents = 370 cents per Bushel and
400 + 30 cents = 430 cents per Bushel
- The price limits during the trading day are set at 370 and 430 cents per Bushel of Corn. If price touches one of these limits during the trading, the traded asset is turned to "Safe Mode".
If you want to see the price limits for the assets, you should visit the stock exchange website. They are usualy listed in the contract specifications. These limits may be changed as the volatility of markets rises, so you should check them permanently. It is interesting that New York Board of Trade does not use the Price Limits. Limit moves may also have other specifics. For example, they need not to be defined on the last trading month in which the contract is traded, while the previous month's limits have been defined.
For a preview of Limit move settings of an Exchange click here. To see how the limit moves are incorporated into individual contracts specifications, click here.
What happens after reaching the limit levels? There are several options. The rules of "safe mode" depends on the particular exchange. Some exchanges cease trading entirely for a specified time. It is also possible to resume trading e.g. 20 minutes before the closing of the exchange. The traders have the opportunity to close their positions, or keep the contracts further, if the emotions in the market are already gone. Other Exchanges do not stop the trading at all. After reaching, the limit the limit price becomes the one below or above which it is not possible to trade contracts. However, the contracts are still traded on the limit price. Of course, the number of contracts that are traders willing to buy/sell is very unballanced and the number of deals is very low. In other words, some traders make to close their positions, others have to hold on.
I attach a screenshot of such situation.
Contracts of December Corn and Soybean oil reached the limit move (red box in the No. 1 and No. 2 lines). Corn fell by 30 cents per bushel, Soybean oil fell by 2.5 cents per lbs.. Soybean oil and corn were locked (Lock limit) at a price that is listed on the left of the Limit move. There is also yesterday's close price showed in the last column. Today's limit price at which the market has been "locked" is in fact yesterday's close price less or more the limit move. As you can see, Wheat, which is mentioned in the box No. 3, is still traded at a market price.
Explanation: The first column: Bid Size, second column: Bid Price, third column: Ask Price, fourth column: Ask Size, fifth column: The limit price, sixth column: Limit move, seventh column: The number of contracts last agreed, eighth column: Yesterday's close price.
Please note the huge difference between the Bid Size and Ask Size for Corn (second row). While approximately 56,000 contracts were prepared for a sale, just 3 contracts were required for a Buy at the Limit price. Panic and the effort to sell at any price is realy huge.
In the end: If, after reaching the limit, the Exchange continues in trading at the limit price, the "unlocking" of the market is not out of the question. The price may get above/below the limit and start to return back to its original value, which in this case is the yesterday's Close (or today's Open).
If, however, we stay locked in the market, without execution of our order to Buy/Sell, an even higher loss, than the limit move, can be suffered. It is also possible that your order will be executed just on the next trading day, somewhere around the Open price, which may be displaced again much lower/higher. For the new day there is a new Price limit, calculated from the yesterday's Close.
In times of great market volatility, there can be several limit moves in a row. Don't rely on the fact, that you are always right or it can't happen to you. Always protect your money with a Stop Loss order.
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