How to Trade Day 4
What Are Price Limits?
Price limits are the maximum amount that the price of a futures contract can go up or down during a single trading session. Futures contracts are agreements to buy or sell something (like corn, oil, or stock market indexes) at a set price in the future. The price limit is designed to keep the market from moving too much in one direction in a single day, which helps control extreme volatility (big, fast price swings).
Tick: This is the smallest price change that a contract can make. So when we say "price limits are measured in ticks," we mean that the limit is broken down into these tiny increments.
Why Do Price Limits Matter?
Price limits help keep trading fair and controlled. They prevent big swings that could be caused by panic or sudden news, giving the market time to cool off. If the market hits these limits, certain things happen, such as:
Trading may be paused: Some markets might halt trading for a little while to let things settle.
Trading could stop for the day: In some cases, the market might completely stop trading until the next session.
Example of Price Limits in Action:
Let’s say you are trading Equity Index Futures (these are contracts based on the stock market, like the S&P 500). These futures have three price limit levels for how much the price can drop:
Level 1: If the price drops by 7%, the market might stop for a bit.
Level 2: If it drops by 13%, more serious actions happen.
Level 3: At a 20% drop, the market stops completely for the day.
In overnight trading, where the market trades outside regular hours, prices can only move up or down by 7%.
Limit Up: If the price reaches the highest allowable level for the day.
Limit Down: If the price reaches the lowest allowable level for the day.
How Price Limits Are Calculated:
Daily Calculation: Price limits are recalculated every day, based on the last price the contract traded at. This keeps the limits updated and relevant to the current market.
Before Expiration: For some markets, like those with physical delivery (e.g., wheat or oil), price limits are removed just before the contract expires. This allows prices to match the real-world value of the commodity.
Differences Between Markets:
Not all futures contracts have the same price limit rules. For example:
Agricultural futures (like corn or wheat) tend to hit price limits more often than Equity Index futures (like S&P 500), which rarely hit limits.
Some contracts have more complex limit systems (like the three-level expansion for Equity Indexes), while others have simpler systems.
Price Banding (Related to Price Limits):
Price banding is another control mechanism, similar to price limits, but it works slightly differently. Price banding prevents trades from being executed outside a certain price range.
If a trader places an order outside the allowed price band, the system will reject it to keep things orderly.
Price bands adjust dynamically based on how the market is moving, which helps to keep trading smooth even during fast market changes.
Key Points for Traders:
Traders Can Place Orders Outside Price Limits: Even if the price hits a limit, traders can still place orders above or below the limit. Those orders will only be executed once the price limit expands or moves back within the allowed range.
Good-Til-Canceled/Date Orders: These types of orders will stay open until they’re filled, even if the price temporarily hits a limit. This is useful if you're waiting for a certain price and want the order to stay active.
Price Limits Rarely Hit: In recent years, with updated rules, price limits are hit less often, but it’s still important to know about them if you’re trading.
Terms to Remember:
Price Limit: The maximum amount a contract’s price can move in one day.
Tick: The smallest price movement a contract can make.
Limit Up/Down: When the market reaches the highest or lowest price allowed for the day.
Price Banding: A mechanism that stops trades from happening outside a set price range, dynamically adjusting to market conditions.
Good-Til-Canceled (GTC) Orders: Orders that stay open until they are either filled or canceled by the trader.
