Limit-Down in the ES explained

After missing a tremendous (and I mean, triple your account-kind of tremendous) opportunity on Monday, I became very determined to understand everything I needed to know in order to never, ever make that mistake again.

Imagine buying the S&P futures at say, 1.  Yes, 1pt. Not two-thousand something.  Imagine buying with NO RISK of your stop being immediately pegged on a sudden price slip or random headline - because the market cannot trade at the price your stop is at.  What would you do when faced with such a trading scenario?

I'd buy every contract available on the maximum margin my broker allows.

Back in the real world where the S&P 500 has never traded beneath 16.66 (the day the index premiered in 1950), buying with basically no downside risk due to the price being so close to zero is a fantasy.  Yet, the events that occurred on Monday revealed the next best thing, and I admit I was completely unprepared to act on it.  I got caught up in the insanity of price like most others, which is usually a recipe for disaster.

What I'm talking about is the e-mini futures trading to the limit-down price 5 minutes into the day - before rallying like Satan himself was on their tail.  Limit prices are an artificial floor (or ceiling) in the market, a brick wall price isn't allowed to punch through, just like the lowest possible price of the index (zero).  They are out there, every single trading session - but it's been so long since we've seen them.  Why? Because this thing is stuck in non-stop rally mode.  Every tiny little liquidation is bought up so fast you have to look close to even know it happened.  Even with the range-bound action in 2015, drastic price declines were a thing of the past, right?  So to be fair, what happened on Monday was something even seasoned pros were surprised by, and had to consult their notes from the bygone years to remember how to engage the situation.

After spending hours researching, on the phone with the CME globex command center multiple times, and reflecting on what exactly happened, I now present the Eric's Future guide to trading with little risk in situations with such extreme volatility that limit levels are hit.

Let's get started by talking about what limit prices even are.  Basically, they are exchange set stopping point prices established to reduce risk and volatility when markets get crazy (and we all know how insane they can indeed be).  How crazy?

Looking at the above excerpt from the CME's price limit FAQ, we can see that during RTH (8:30-3:15 CT) the limit prices begin to come in play at the 7% threshold.  Imagine a day with a 7% swing! Well, I guess you don't need to, just think back to Monday.

Now let's talk about how these price limits are implemented in the ES.

In the overnight session, a 5% limit-down price is always in effect.  Since the cash market is closed, this -5% price can only act as an artificial floor, and not trigger any trading halts (more on that later).

What this means is that the lowest the market can be offered is at a 5% decline from the current settlement price, set at the close of the previous session.  No need to break out calculators, the CME maintains a list of current limit prices here, along with a little bit of explanation of how they're computed should you be curious.

Now, this is important: regardless of what happens during the overnight, on the opening bell at 8:30 CT new limit prices are in effect.  It does not matter if the overnight traded down to the -5% mark, as it did on Monday, new price limits come into effect.  If the overnight was not volatile at all, say it opens right around settlement - the new price limits always come into effect, with the first limit-down price now at -7%.

The reason this occurs is so the derivative market (the futures) are in sync with the underlying index (the "cash market" in New York), as described in the excerpt above.  Both markets are now operating with the same limit price parameters in play.

The 2015 trade of the year....

Unlike other markets, the S&P futures market is unique in terms of the sequence of events that occur once limit-down prices are hit.  As it turns out, both its value and its limit price behavior is a derivative of the cash index traded in New York.  How it works:

• During US market hours, a 7% price floor is always in effect in both futures and the cash market.
• If the limit-down price of -7% is offered in the futures market, it simply acts as an artificial floor.  Price is not allowed to trade beneath it.
• If the limit-down price of -7% is offered in the cash market, NYSE rule 80b comes into effect and a trading halt will occur in both the futures and the cash markets for 15 minutes.  The futures market will enter a 'pre-open' market state.  Orders can still be placed/pulled/modified, just not matched.
• Upon re-opening, both markets will now have the next limit-down price in effect (Level 2 price of 13%).

With these key points in mind, let's take a look at what the cash market was doing at the time the futures were down at their limit price:

A different price vs futures

And now a summary: the ES opens at -5%, and with that floor now no longer in effect (because during US hours the level 1 price limit is -7%) it plunges down immediately.  Total panic sets in and the index futures traveled down to the limit-down price at -7%, or 1831, within one minute.

Meanwhile in New York, the index is a ways off from the level 1 limit down price.  Looking at the 5-minute chart above, we can see that it barely gets beneath 5% at the time the futures market was trading at the limit-down price.  And we also know that trading will halt in the futures market only if New York trades down to -7%.

Do you think the ES is just going to sit there at -7%, twiddling its thumbs while New York catches up?  Unlikely.  Time is a big part of any advantage in the current markets.  Instead, some saavy traders saw an opportunity to play an arbitrage game between the two indices, since the futures market was way out of sync with the index it's supposed to derive its value from.  They managed to scoop up 6k+ lots at the low.

This quickly turned into some buy-side aggression, scaring out the weakest of the shorts (really, who waits until the market is at a limit-down price to sell!?) and fueling a rally on the back of a big decline driven by mostly weak and emotional money in preceding sessions.  That money bailed fast and hard.  How big of a rally was it?

In case you use T4, here's what to look for on your DOM

Yes, 120+ points.  Even one-lot traders would be blown away at the value of that trade.  And best of all? It was basically risk free.

"Basically" because the only way trade would not have worked out if 1) New York traded down to its level 1 limit, triggering a trading halt in the futures market, which upon ending would've likely 2) caused more selling, whammying your stop.  But if your stop is right beneath the limit-down price, say at 1830.75, you're first in line to be filled.  It's reasonable to think there would be some slippage, but not so much to worry about.

But that really wasn't a concern due to the large price discrepancy between the two indices, and was a huge reason the deck was stacked in your favor.


UPDATE: June 24 2016  - The CME has created a comprehensive FAQ on how price limits work in the S&P 500 markets, which goes into even greater depth than this post.