Sometimes referred to as a daily trading limit, the limit down is the highest amount of decline that the price of a commodity futures contract may experience in a single trading day before trading on that contract is halted. In some settings, the term is also used to identify the maximum amount of increase in the contract’s price that can be achieved on a single trading day, although this application is far less common. In general, the idea of the limit down is to prevent extremes that would possibly undermine the integrity of the investment. Should the price move away from the limit down before the end of the trading day, there is a good chance that trading on that investment will be allowed to begin again, rather than waiting until the following day.
One of the reasons behind the establishment of trading limits is to provide some checks and balances in a marketplace, even when extreme events take place. With a limit down, the futures market is attempting to protect itself and as a result its investors from experiencing what could be serious consequences as the result of unforeseen events. Since it can take several days for the effects of some type of catastrophic market event to impact a futures contract, investors have the opportunity to make decisions on what do with their holdings. At the same time, the trading limits provide a window of breathing space, making it possible for prices to only plummet so far as the after-effects of the crisis are manifest. Within a few days, as the market begins to recover, trading on the futures contracts can resume and the up and own movement of the price can continue at a more balanced pace.
While a limit down does offer some degree of protection to investors, it also offers some opportunities for those that choose to purchase the contracts at low prices just before the freeze is implemented. The assumption is that they can benefit from the discounted purchase by holding onto the futures contracts through the hold on the trading and hopefully emerge with an asset that can be sold at a profit a few days or weeks down the road. Understanding what type of effect various events will have on the assets underlying the futures contract, if and when a limit down is expected to be reached, and how to respond in order to gain the most benefit from the situation is essential if the investor wishes to avoid losses.
The limit down is one of many trading limits that can be used by investors to protect their financial positions and possibly even implement a strategy that serves them well later on. Often, knowing the limit down makes it easier to develop contingency plans in advance, based on projections of what would happen if the market moved in a given direction within a specified period of time. Employing strategies of this type make it easier to respond to the pending implementation of a limit down in a way that ultimately yields benefits that would have been missed otherwise.