Major exchanges on which financial securities trade have to set parameters so that there is order and accountability in the markets, where large sums of money are traded each day. A price limit is one such measure, and it is most effective in the trading of derivatives. In the markets, a price limit occurs when a derivative security, such as a commodity or options contract, reaches a certain price threshold to the upside or the downside. Once that level is attained, trading stops in that financial security until the following trading day. It is a protective measure against erratic trading, fraud, or other manipulative behavior in the markets.
When a derivative security rises to a certain price, or drops below a given level, a price limit goes into effect. The exchange on which the commodity or options contract trades, such as the CME Group in the U.S., in Chicago, Illinois, is responsible for enforcing the suspension of trading. It may seem that traders are being prevented from earning profits on a specific financial security, but the purpose of a price limit is to protect traders and investors alike. The protective measure is from honest but extreme market swings in the derivatives markets in addition to potential price manipulation that could result in extreme volatility.
There are large sums of money at stake in all of the financial markets, including where stocks and bonds trade in addition to the market for derivatives. Financial stakes become even higher when traders add leverage, or debt, to a trade to mitigate potential losses and enhance profits. This is one reason why a price limit becomes so important, because when a trader is hedging a position, or trying to narrow the distance between a gain and a loss, erratic price moves can be especially damaging.
Once an exchange sets a price limit, the results should be posted on the exchange's website for market participants to see. After a price limit has been set, it can be changed at the market's urging. If an exchange deems that an options or commodities contract is reaching its pricing limit too frequently, it may issue a vote to approve a change in that trading threshold. Changes could potentially unfold across the board in all types of commodities, or the adjustment could focus on a particular crop, such as corn. An exchange's decision to change price limits could be based on perception of the way that the derivatives' markets are functioning, and some market participants may disagree.