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?
Creating Synthetic Futures
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.
Calculating Implied Futures
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.