What is a Daily Trading Limit?
A daily trading limit is the maximum amount, up or down, that a exchange traded security is allowed to fluctuate in one trading session. It is often used in the derivatives market, especially for option or futures contracts, to harness the excessive volatility that can ensue in one trading session. Daily trading limits are imposed by securities exchanges to protect investors from extreme price movements and discourage potential manipulation within the markets.
Understanding Daily Trading Limits
Daily trading limits, also known as daily price limits, are price ranges established to curtail excessive volatility that can be detrimental to the orderly functioning of markets, especially in the highly volatile derivatives arena. 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.
- Once a price limit has been reached, trading can still continue at that limit but the price will not cross the price set for the daily trading limit.
- A market that reaches its daily trading limit is referred to as a 'locked' market. Other descriptive monikers include 'limit up, or 'limit down' depending on the whether the upper or lower end of the range has been reached.
- At times, daily trading limits may be removed during the expiration month of a derivatives, usually futures, contract because prices can become especially volatile. Traders may not want make trades during these periods because price fluctuations can become extreme.
- Daily price limits are used in the foreign exchange markets as well where a country's central bank imposes limits to reduce the volatility of it's currency. The most notable example of this currently is China which has a daily trading limit of ± 0.5%.
Here’s a hypothetical example: suppose the daily trading limit for a particular commodity 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. If either of the daily trading limits were to be reached then this commodity would be deemed to be a 'locked' market. It would also be described as having gone 'limit up' or 'limit down' based on whether the upside or downside limit was reached.
- A daily trading limit is the maximum amount, up or down, that an exchange traded security is allowed to fluctuate in one trading session.
- Daily trading limits are imposed by securities exchanges to protect investors from extreme price movements and discourage potential manipulation within the markets.
- Daily price limits are used in the foreign exchange markets as well where a country's central bank imposes limits to reduce the volatility of its currency.
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 once the respective extreme has been reached.
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.