Earlier this week> we covered the disruptive and destructive effects of trading limits: how they make markets less liquid, more volatile and more likely to collapse.
Turns out there is an extremely reliable trading strategy, or at the very least a trading tool, that directly exploits those constraints, particularly within commodities, where artificial limits have handcuffed trade for decades.
First popularized in 1977, Howe s Limit Rule proposes that market limits, once reached, will almost always be retested and ultimately exceeded, at least briefly, and usually within a matter of days. The theory is that trading limits, which are tracked by Moore Research Center, leave the market unsatisfied, unsure of just how far and fast prices would continue to move absent the halt, and thus very likely to revisit that level to find out.
In other words, reality exists: Markets are going to move in accordance with supply and demand, regardless of what artificial obstacles regulators put in the way. Moore s research shows trading limits are nearly always exceeded a rare opportunity where a technical indicator suggests a specific target level rather than a general range.
An extensive library of data supports the claim. Within corn, for example, now easily tradable using products like
), corn prices that traded limit up or limit down have
exceeded those limits 74% of the time within three days after being hit.
Wheat, heavily weighted in products like PowerShares DB Agriculture Fund or iPath Grains ETN, shows similar tendencies. Limit moves in wheat are likely to have their price exceeded approximately 68% of the time within one day, and nearly 90% within a week. I m not aware of any other trades in the market that offer such a high degree of certainty.
When a market hits a limit, short-term traders can confidently trade in the direction of the prevailing trend at the first possible opportunity, knowing the price will almost always be breached. Those holding winning positions should let their winners run, even after a limit is hit, and daring contrarians wishing to take the opposite side of the trend are well advised to wait until at least the limit price is exceeded as it almost always is.
Unless you are a scalper or floor trader, playing a bounce off a limit move is dangerous, says Jerry Toepke, Editor of Publications at Moore Research Center. The odds are very likely the price will be penetrated and extremely likely within four to seven days.
In commodities, hitting the often outdated and arbitrary limits is relatively common: Lumber has gone limit up an incredible 2,173 times since 1974, for example. But because stock index limits have historically been wider (currently: drops of 10%, 20% and 30%), they ve been hit far fewer times.
That s likely to change very soon. As has been reported, the SEC is now considering a futures-style limit up/down system for individual stocks, meaning hundreds or even thousands of individual securities could soon be impacted by new restraints, constantly getting halted intraday. The SEC s pilot program, recently expanded to 1,000 stocks, has already produced ten mini-crashes since June.
And for whose benefit? Besides creating unnecessary volatility and sapping liquidity, Howe s Limit Rule suggests all those artificial boundaries are ultimately exceeded anyway.