If you’re in a position you can’t access while in a locked-limit scenario, consider constructing a synthetic futures contract to offset your position.
Risk Happens. So prudent traders define their loss ahead of time and use stop orders to get out when they need to, right? Maybe not. There’s one scenario in the futures market that won’t let you out at any price. That’s when the market is “locked limit.” No safe stops here.
Locked limits, either up or down, occasionally occur when a futures contract exceeds its daily maximum price move. Trading is suspended for the day, sometimes multiple days, until a price is found that attracts both buyers and sellers. “Locked-limit down” means you won’t be able to sell during the locked period. “Locked-limit up” means you won’t be able to buy (or cover a short position) during the locked period. Such a move might go against you, and right past your stop, with no way to exit your position. What’s a trader to do?
While an underlying futures contract is inaccessible in a locked-limit scenario, typically you can still trade futures options. You’re probably not the first person to think of this, so you’ll have to act fast. Your main concern is to contain your loss as much as possible by constructing a synthetic futures contract to offset your position.
If you’re long in a limit-down situation:You’ll need to construct a synthetic short by simultaneously buying an at-the-money (ATM) put and selling an ATM call. This options strategy simulates the payoff of a short futures contract, thereby offsetting your long contract and in theory preventing further loss.
If you’re short in a limit-up situation: You’ll need to construct a synthetic long by doing the opposite—simultaneously buying an ATM call and selling an ATM put. This strategy simulates the payoff for a long futures contract, thereby offsetting your short contract and in theory preventing further loss.
A synthetic futures position can be created in TD Ameritrade’s thinkorswim® trading platform by right-clicking an at-the-money option, hovering over buy or sell, then selecting Collar/Synthetic (Combo). For illustrative purposes only.
During a locked-limit period, traders might not know the exact implied ATM price. Fortunately, you can also use options to estimate the market’s perception of the price of underlying futures with this formula:
Implied futures price = strike price + call price – put price
For example, suppose you’re long a contract of the September E-mini S&P 500 futures at $2,100. The Sep 2100 call is priced at $35, and the Sep 2100 put is priced at $75. Applying the formula, you get:
2,060 = 2,100 + 35 – 75
The market is implying a current price of $2,060. If you construct your offsetting synthetic contract at or near this price, you’ll potentially be locking in a $40 loss ($2,100 – $2,060). For the E-mini S&P 500, this equates to a potential loss of $1,750 per contract.
Locked-limit moves are rare, but are known to happen as a result of a news event or drastic change in a commodity’s supply. It only takes one of these events to wipe out a whole year of profits (or worse). Using synthetic futures as a backup plan could mean surviving to trade another day.
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC, a subsidiary of The Charles Schwab Corporation. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2021 Charles Schwab & Co. Inc. All rights reserved.