Limit Moves In Futures Trading

The soybean futures market went limit-up at the open on Friday (29 June, 2007).

Limit days are one of the reasons I prefer day-trading to other trading styles where positions are held for days or weeks. Imagine you had been long when the market closed on Thursday. Then you would be delighted with the action on Friday, sitting on a large windfall profit!

But imagine for an awful moment that you were short on Thursday close with a stop placed 5 points above the close. When the market opened on Friday your stop would have been triggered, but if the stop order was actioned at all it would have been at around 50 points above the previous close! That is an instance of the market gapping through your stop loss and inflicting far greater losses than you had anticipated - ten times more in this case.

But that is not the half of it! More than likely, the stop order would not execute because under the rules for trading this contract, the market was locked limit up (50 points) for much of the session and trading was suspended. Fortunately, on this occasion, price pulled back late in the session allowing trading to recommence, so your stop would have executed before the end of the day. But imagine how you would feel if the market remained limit up into the close. You would endure a miserable weekend wondering if Monday would be another limit up day, costing you another 50 points with no way to exit your trade. Indeed, it is possible to have a run of several limit days in succession, with disastrous consequences for your account.

Of course, markets can gap through stop loss points when day-trading as well, but it is much rarer than when you hold positions over night or across weekends. The day-trader always closes outstanding positions before the end of the primary session, so is not nearly so exposed to dramatic moves through stop loss points.

Is there anything you can do about limit days? The best defense is to protect your position with futures options instead of normal stops. For example, when you go short soybeans at, say, 840 you may be able to purchase the 840 futures call option for 18 points ($900). If you choose to execute this option, you are granted a long futures contract at 840 points. This means that no matter how high the market goes, you cannot lose more than 18 points (because your 840 short is offset by the 840 long, so your only exposure is the 18 point premium).

This insurance will cost you, of course, because if you exit your short position at, say, 820 for a 20 point profit, you will find that the price you get for your 840 futures call will be much less than you paid. If you can get 6 points for it, you have made 20 points on your short futures position, but lost 12 points on your long call position, giving a net profit of 8 points. For the long term trader, this may be less significant. For instance, if the market declines over a few weeks to 700 giving you a 140 point profit, your futures call option will almost certainly have lost the full 18 points of value, but this still leaves you a full 122 point profit and lets you sleep easy through events like limit up days.

Even if you decide against using options in your normal trading strategy, they might still save your bacon in an emergency. When the US experienced the first discovery of Mad Cow Disease the futures market for live cattle went limit down for several days. This was in a period where there had been a sustained up-trend in cattle prices, so many traders were caught in long positions. The thing to remember is that when the futures market goes limit up or down, trading is suspended in futures contracts but not in futures options. Therefore, when the live cattle went limit down, it was still possible to buy futures put options which would serve to protect against further major declines. The problem with this is that the put option premiums are sky high in this scenario, so you will still incur a very substantial loss. Still, if you want to get out at all costs and the futures market is locked, this is the way to do it.

The other thing to notice from this discussion is the importance of trading small. If you are trading too many contracts and get caught on the wrong side of a limit move, you can be wiped out in a flash. That is why professional traders limit planned exposures (their planned stop loss points) to less than 2.5% of their overall account. Even if a disaster occurs, and they suffer a loss 10 times greater than they planned for, they are still in the game. Anybody risking more than 4 or 5% is likely to be dealt a blow from which they cannot recover, and anybody risking 10% or more is dead in the water.

A further consideration is that limit moves following sudden bad news are often over reactions. If your position is small relative to your account size, you will have the capacity to ride out the storm, and exit at much better prices when the first panic recedes and prices retrace towards former levels. Traders carrying too much risk will not be able to do this because they will suffer margin calls and be forced to exit contracts at the worst possible time.

What Is A Futures Contract?

Futures contracts are based on a standardised unit of some commodity. For example, 5,000 bushels of No. 2 yellow grade soybeans.

Some contracts are based on artificially created commodities. For example, 5 times the Dow Jones index. (If the Dow Jones Index is 10,000 then this contract value would be $50,000.)

The only criterion that the underlying commodity unit has to meet is that it is unambiguously defined.

A futures contract is either a commitment to buy (LONG) or to sell (SHORT) the standard unit of the commodity at a specified future date.

There is no requirement to own the commodity before entering a short contract. This sometimes confuses people. How can I sell something I don’t own? The answer is that it is a futures contract. When you go short, you are committing to sell at a future date, not now. Of course, if you don’t own the underlying commodity at the moment, you will need to buy it before the contract expiry date. Alternatively you could enter a long contract to cancel out the short position.

Only commercial operators plan to hold futures contracts through to delivery dates. This enables them to fix prices in advance, making it easier to manage their businesses.

Futures contracts are not personalised and can be bought and sold on a futures exchange. The prices at which the contracts are traded vary as the value of the underlying commodity fluctuates.

Speculators buy and sell futures contracts depending on their view of the price movement of the underlying commodity. They do not hold them until the contract expiry date, because they have no wish to deliver or take delivery of the commodity.

A speculator enters a long trade by buying a contract, and exits the trade by selling it. This is profitable if the value of the underlying commodity increases. For example, if soybeans increase in price by $0.02 per bushel, the contract value increases by $100 (5,000 X $0.02).

A speculator enters a short trade by selling a contract, and exits the trade by buying it back. This is profitable if the value of the underlying commodity decreases. For example, if a trader shorts the futures contract based on the Dow Jones index just before it falls 30 points, the contract value decreases by $150 (30 X 5). The trader buys it back at the lower price to realise the profit.

Contracts are traded on futures exchanges around the world. Two large exchanges in the US are the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT). Look under the Products links on these web sites to see the range of contracts available and to examine the contract specifications.

Futures Trading

All futures contracts are generally made for the purpose of speculation or hedging. As such, the general procedure for settlement is the neutralization of the original contract by an opposite contract on settlement, so that only difference between the current and the contract price is paid or received. It is rare that actual delivery of the goods is taken, and the price paid in settlement of futures contracts.

Futures trading is the most notable feature of business activity on the commodity exchange. In fact, the commodity exchanges are organized mainly for futures contracts. The futures contracts are made for two distinct purposes: speculation and hedging. Accordingly, they are either speculative or hedging contracts. Speculative activity is such an important part of the commodity exchanges that commodity exchanges are sometimes referred to as the speculative market.

All speculation represents an attempt on the part of individual to peep far into the future out of the window of the present. Speculation refers to an attempt to estimate the future trend of prices and proceed on that basis, to result in profit. Commodities may be bought at the current price with the assumption of selling them at a higher price in future or vice-versa.

What are Your Options Regarding Forex Options Brokers?

Forex option brokers can generally be divided into two separate categories: forex brokers who offer online forex option trading platforms and forex brokers who only broker forex option trading via telephone trades placed through a dealing/brokerage desk. A few forex option brokers offer both online forex option trading as well a dealing/brokerage desk for investors who prefer to place orders through a live forex option broker.

The trading account minimums required by different forex option brokers vary from a few thousand dollars to over fifty thousand dollars. Also, forex option brokers may require investors to trade forex options contracts having minimum notional values (contract sizes) up to $500,000. Last, but not least, certain types of forex option contracts can be entered into and exited at any time while other types of forex option contracts lock you in until expiration or settlement. Depending on the type of forex option contract you enter into, you might get stuck the wrong way with an option contract that you can not trade out of. Before trading, investors should inquire with their forex option brokers about initial trading account minimums, required contract size minimums and contract liquidity.

There are a number of different forex option trading products offered to investors by forex option brokers. We believe it is extremely important for investors to understand the distinctly different risk characteristics of each of the forex option trading products mentioned below that are offered by firms that broker forex options.

Plain Vanilla Forex Options Broker - Plain vanilla options generally refer to standard put and call option contracts traded through an exchange (however, in the case of forex option trading, plain vanilla options would refer to the standard, generic option contracts that are traded through an over-the-counter (OTC) forex dealer or clearinghouse). In simplest terms, vanilla forex options would be defined as the buying or selling of a standard forex call option contract or forex put option contract.

There are only a few forex option broker/dealers who offer plain vanilla forex options online with real-time streaming quotes 24 hours a day. Most forex option brokers and banks only broker forex options via telephone. Vanilla forex options for major currencies have good liquidity and you can easily enter the market long or short, or exit the market any time day or night.

Vanilla forex option contracts can be used in combination with each other and/or with spot forex contracts to form a basic strategy such as writing a covered call, or much more complex forex trading strategies such as butterflies, strangles, ratio spreads, synthetics, etc. Also, plain vanilla options are often the basis of forex option trading strategies known as exotic options.

Exotic Forex Options Broker - First, it is important to note that there a couple of different forex definitions for "exotic" and we don't want anyone getting confused. The first definition of a forex "exotic" refers to any individual currency that is less broadly traded than the major currencies. The second forex definition for "exotic" is the one we refer to on this website - a forex option contract (trading strategy) that is a derivative of a standard vanilla forex option contract.

To understand what makes an exotic forex option "exotic," you must first understand what makes a forex option "non-vanilla." Plain vanilla forex options have a definitive expiration structure, payout structure and payout amount. Exotic forex option contracts may have a change in one or all of the above features of a vanilla forex option. It is important to note that exotic options, since they are often tailored to a specific's investor's needs by an exotic forex options broker, are generally not very liquid, if at all.

Exotic forex options are generally traded by commercial and institutional investors rather than retail forex traders, so we won't spend too much time covering exotic forex options brokers. Examples of exotic forex options would include Asian options (average price options or "APO's"), barrier options (payout depends on whether or not the underlying reaches a certain price level or not), baskets (payout depends on more than one currency or a "basket" of currencies), binary options (the payout is cash-or-nothing if underlying does not reach strike price), lookback options (payout is based on maximum or minimum price reached during life of the contract), compound options (options on options with multiple strikes and exercise dates), spread options, chooser options, packages and so on. Exotic options can be tailored to a specific trader's needs, therefore, exotic options contract types change and evolve over time to suit those ever-changing needs.

Since exotic forex options contracts are usually specifically tailored to an individual investor, most of the exotic options business in transacted over the telephone through forex option brokers. There are, however, a handful of forex option brokers who offer "if touched" forex options or "single payment" forex options contracts online whereby an investor can specify an amount he or she is willing to risk in exchange for a specified payout amount if the underlying price reaches a certain strike price (price level). These transactions offered by legitimate online forex brokers can be considered a type of "exotic" option. However, we have noticed that the premiums charged for these types of contracts can be higher than plain vanilla option contracts with similar strike prices and you can not sell out of the option position once you have purchased this type of option - you can only attempt to offset the position with a separate risk management strategy. As a trade-off for getting to choose the dollar amount you want to risk and the payout you wish to receive, you pay a premium and sacrifice liquidity. We would encourage investors to compare premiums before investing in these kinds of options and also make sure the brokerage firm is reputable.

Again, it is fairly easy and liquid to enter into an exotic forex option contract but it is important to note that depending on the type of exotic option contract, there may be little to no liquidity at all if you wanted to exit the position.

Firms Offering Forex Option "Betting" - A number of new firms have popped up over the last year offering forex "betting." Though some may be legitimate, a number of these firms are either off-shore entities or located in some other remote location. We generally do not consider these to be forex brokerage firms. Many do not appear to be regulated by any government agency and we strongly suggest investors perform due diligence before investing with any forex betting firms. Invest at your own risk with these firms.