When a Protective Stop in the Market is of No Use
When a Protective Stop in the Market is of No Use
In all of our classes we instruct at Online Trading Academy, we always stress the importance of having a protective stop in the market when you have an open position. Using this strategy will keep you from getting emotionally attached to your position and not being able to pull the trigger when it comes time to take a loss if needed. Plus, we can control how much we are willing to lose on any given trade. In fact, this is the only thing we have any control over when we are trading and that is the amount we are willing to lose on any given trade. We have no control over how much profit a market will give us once we get in the trade.
ADVERTISEMENTAs good as it is to have these protective stops in the market, there are times when they are useless for protection against a large loss. For now, just keep in mind that when a protective stop is executed by the market, your order becomes an instant market order and is subject to slippage on the fill. Now let's look deeper into these Limit and Locked Limit days.
A Limit move is a price that is set by the Futures Exchange to limit the amount a market can trade above or below its previous day's settled price. Once the price reaches these price Limits, the market must stop trading in that direction for the day. For example, Corn has a 30 cent price Limit for each trading day. If Corn closed the previous day at $5.50, then the following day Corn would have an upside Limit of $5.80 ($5.50 + .30). That same day Corn could not trade any lower than $5.20 ($5.50 - .30). If the market trades up to its daily high limit, then there can be no more buying beyond that price. You can still sell the market short at this level, you just cannot buy it. The same on the downside occurs when you reach a Limit move below the previous day's settled price. You cannot sell the market lower than the Limit down, but you can still buy it there.
If a market closes up or down its Limit for the day, it is said to be Locked Limit up or down, depending on if the market closed above or below the previous day's settled price. When this happens, the Exchanges will expand the daily Limit price by 50%. This means that the day after a market closes Locked Limit up or down that the next day's Limit from yesterday's settled price will be .45 instead of .30 in the Corn market. Each Commodity with Limit moves will have their own unique daily Limits. Again, you must know the market you are trading. A Locked Limit close of $5.80 will mean that the next day Corn will be able to trade the expanded Limits (.45) up to $6.25, and down to $5.35 before trading is halted once again.
The reason for these price Limits is that the Exchanges feel that if the trading stops and traders go home and sleep on it, they will come back the next day and be more rational and less emotional. Usually these Limit moves occur after a Supply/Demand report or some other news event that usually just shocks people into becoming very emotional. Another reason for these Limits is that it serves to protect traders from very large swings during the day and causing traders to lose money they cannot afford to pay back. Both of these reasons have been discussed for years as to their validity. Seems everybody has their opinion about Limit moves and whether we should have them or not.
Several Commodity Futures contracts have these Limit days associated with them. There are many that do not have any daily limits. And then there are some that only have Limit moves to the downside (these are in our Stock Index Futures only). It is important that you know if the market you are trading has Limits. You can easily find out by visiting the Exchange website where the Commodity trades at and looking under the contract specifications page. Look for a line in the specifications page that says "Daily Price Limits." If your Commodity has a Limit, you will see the amounts posted here. If not, then the comment will be "No Daily Price Limits."
Let's review a recent day in the Corn market when we saw these extreme moves. On October 8th, 2010, the United States Department of Agriculture (USDA) released the monthly Supply/Demand numbers for the grain markets. Corn had already been in an extended uptrend and had reached a psychological resistance level of $5.00. Many of the Index Funds had long positions in Corn coming into this report. I will be writing about these Funds next week. The report caught the market off-guard and showed a 4% reduction in this year's Corn yield estimate. Remember, at this time, all the Corn has not been harvested and traders are still trying to get a handle on the true supply of Corn that will be harvested this year. Some rumors hit the market after the report that there may be some demand rationing that could actually push prices up to $6.00 or higher per bushel. Since Corn in the United States is primarily used to feed livestock, the Live Cattle and Lean Hog markets felt the impact of these future higher feed prices.
The following charts will show you how these Limit moves looked on the charts, both daily and intra-day.
Figure 1
Figure 1 shows a Daily chart for the December Corn contract. Coming into the trading day of October 8th, the day the USDA report was scheduled to be released, we can see that the previous day's settle price (A) was 498 '2. Corn trades in .25 increments just like the E-mini S&P contract does and the value is $12.50 per tick or $50 per full point. The price looks a little different than the E-mini S&P:
- '2 = .25
- '4 = .50
- '6 = .75
The daily Limit on Corn is .30 and if we add that to the previous settle price of 498 '2 (A), we have an upside daily Limit in Corn on October 8th of 528 '2 before no more buying can come into the market. You can see that after the USDA report was released, the Corn market closed at 528 '2 (B) for the day. The close of this day is $1,500 (30 * $50) per contract higher than the previous close at (A). Since the market closed at the Limit price, the correct term for this is Locked Limit up. If the market had traded down after hitting this price, it would have been called a Limit move instead. When a market closes Locked Limit up or down, the Exchanges will usually expand the daily price Limit for the next trading day. In the case of Corn, the Limit goes from .30 to .45 added to the previous settle price. October 8th was a Friday and when the market opened again on Monday, October 11, the new up Limit was 573 '2 (Previous close + .45). Notice how the market gapped up on the open to Limit up (C). This gap up into a Limit was a move of $2,250 per contract. The rest of the day the Corn market traded down from the Limit price. Since Corn did not close Locked Limit up again, the Exchange went back to the usual .30 Limit the following day.
Now let's look at this on an intra-day chart and see just what it looked like as the market digested this news. Look at Figure 1, again, and notice how there is no gap showing on the daily bar for October 8th. The intra-day chart shows that unseen gap.
Figure 2
Each day the Grain markets suspends trading from 8:15 ñ 10:30 am EST. This is also the time the USDA releases the monthly Supply/Demand report. Again, they feel people will have time to digest the news and react rationally. In theory, everything works, right?
In Figure 2, we can see that when trading was suspended on October 8th, we were trading at 496 '4 (A). The report was released and when trading resumed at 10:30 EST, the market literally opened Limit up. This means that anybody who was short this market could not get out unless the market trades off the Limit move. No protective stop could have helped you here. The gap between point A and point B had absolutely no trading in between to offer anybody with a protective stop to get filled. If you were short from the previous day's close, you are now losing $1,500 per contract and have no way to get out of your trade.
Notice how the horizontal dashes go across the screen at (B) 528 '2. This means, again, there was absolutely no trading going on to allow shorts to cover. The market closes Locked Limit up this day. So now, these poor people who are short the market will be carrying a losing position over the weekend with no way of getting out.
After the market went Locked Limit, professional traders were still trading Corn to the Long side. How can they do that? We are Locked Limit up, right? They were putting on what is known as Synthetic Long positions using Options and back month contracts of Corn to Spread their positions. Many traders knew that Corn would open the expanded up Limit Sunday night before the market closed on Friday because of all the Synthetic Long positions that were being established.
For people who did not know about Spreads and Options, they were stuck in their outright Futures positions waiting for the first chance to exit this losing trade. When do you think that chance came? You got it, Sunday night. The Corn market opened up just like it was projected to into its expanded up Limit. This was a gap up of .45 from the previous close at (B). In cash terms, people who were already down $1,500 per contract have now just lost another $2,250 per contract. Many had sell on open orders for Sunday night and just wanted out. They got their wish once the market traded off of its up Limit move. In total, these people stood to lose $3,750 per contract on this one trade. For many with small accounts, this could have been an easy 50% cut in their account size or more. Then you have the traders who trade more contracts than their account can handle and could possibly have lost much more if you multiply the number of contracts held times the per contract loss amount. We discuss in class that you can always lose more money than what is in you trading account. Locked Limit moves are the exact reason for this. If you had $5,000 in your trading account and this market went Locked Limit for another 2 days, you would have owed your broker an additional $6,250 and that is just trading one contract. This is not to scare you away from Futures trading, but simply a warning of the consequences you need to be aware of.
If you are ever trading a Futures contract before a major report, you have a couple of choices to help protect yourself.
First, get rid of your protective stop the day before the report comes out near the close of the day. If you are Long the market, buy an in the money Put Option. If you are Short the market, buy an in the money Call Option. Keep this Option in play until about an hour after the market opens the next day, after the report is released. We do not always go Limit after these reports, but usually just get a wild knee jerk reaction for the first hour. After the market calms down a bit, get rid of your Option protection and re-place your original protective stop back in the market.
Another tool is to look at Spreading off your position. If you are Long the December Corn contract, then look to remove your original protective stop the day before the report and replace it by selling a different contract month of Corn. For example, be Long December Corn and Short March Corn. Then after the market calms down after the report is released, simply offset your Short March Corn contract and place your original protective stop back in the market.
Some people will say, "If I protect myself with these tools, then I stand to miss out on making a lot of money." That is very true, but like any professional in the trading business, you will be protecting yourself against an adverse move against you. Capital preservation is the key in trading.
There are risks in trading Futures, but if we understand them before going into the trade, we can form strategies to protect us from the dangers. Of course, we will lose money while trading; nobody can guarantee you anything different. Controlling how much we lose is crucial to our financial survival in the trading arena.
"The only difference between successful people and unsuccessful people is extraordinary determination." Mary Kay Ash
- Don Dawson
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