What is Daily Trading Limit
A daily trading limit is the maximum allowable amount of money that an investor can gain or lose on a derivative contract, such as an option or futures contract, in any one trading session. The limits are imposed by securities exchanges to protect investors from extreme volatility or any manipulation within the markets.
BREAKING DOWN Daily Trading Limit
Daily trading limits, also known as daily price limits, are price ranges established for derivative contracts, such as futures or options. Once a price limit has been reached, the derivative cannot be traded for more or less than that price until the following trading day. The purpose of daily trading limits is to lower the chances for extreme market volatility or manipulation in relatively illiquid markets, especially since derivative markets are characterized by their high levels of leverage.
Here’s a hypothetical example: suppose the daily trading limit for a particular grain was $0.50 per bushel and the previous day’s settlement was $5.00. In this case, traders cannot sell for less than $4.50 or buy for more than $5.50 per bushel during the current session. A market that has reached it daily trading limit is said to be a “locked market.” It’s also known as “limit up” or “limit down” contingent upon on whether the upside or downside limit was reached.
Sometimes, daily trading limits may be removed during the expiration month of a derivatives contract, because prices can become especially volatile. Traders may not want make trades during these periods because price fluctuations can become extreme.
How Daily Trading Limits Impact Traders
Daily trading limits can significantly affect trading given that prices can potentially move higher or lower much more quickly.
For example, U.S. wheat futures locked up 30-cent daily trading limits in early 2008 for several consecutive sessions amid heavy buying from both speculators and grain users. The underlying cause of the volatility was driven by an uncommon amount of crop losses that reduced supply. Some exchanges responded to the issue with higher daily trading limits to allow the commodity to reach market prices, and tried to suppress speculator demand with increased margin requirements.
Currency markets are a popular example of daily trading limits imposed by central banks to control any instability. For example, the Chinese renminbi had a daily trading limit of 0.5 percent against the U.S. dollar to help subdue volatility. Central banks would defend these trading limits by changing the composition of their currency reserves.
Daily trading limits can also influence asset valuations. For example, fundamental factors may have an effect on the true value of a futures contract or currency, but an inability to proficiently reach that price could cause an asset to be valued inappropriately.