Saturday, April 01, 2006

Limit Price Tip

Limit Price Tip

Here?s another term that we heard regularly during the stock market bubble of the 1990s but not much since the millennium. It?s an artificial ?circuit breaker? designed to prevent a spark of buying or selling from exploding into a full-blown panic.

The various futures markets set a ?limit? price before each session based on the settlement price at the end of the previous day?s trading. If the price of a particular futures contract hits the limit price, trading is suspended for a specific period of time. When trading resumes, the limit price is as far as the action can go. There is a ?limit up? for buying sprees and a ?limit down? for major sell-offs. If the contract is limit up or limit down for more than one day it is now ?lock limit.?

Future contracts cover a large number of commodities. Stock traders in particular watch the DOW futures and the NASDAQ 100 futures. The action in those futures pits, especially before the opening bell for a new session at the NYSE or NASDAQ, helps traders determine whether the open for the cash market will be strong or weak or going nowhere. If the DOW futures are soaring, traders tend to go long; if they?re collapsing, traders tend to go short.

Limits are set in place to prevent the buyers or sellers from taking the index too far, too quickly.

For example, the NASDAQ 100 has an initial limit at 20 points above or below the previous day?s settlement price. The limit is in effect for two minutes. When trading resumes, the next limit is at 30 points, and it is in effect for 15 minutes. Then comes 60 points for 30 minutes and 85 points for one hour. When the change is 100 index points up or down, it is at lock limit.

The limits are tested in most cases by news events. A horrible headline can send the futures to their limit in a flash. The last time we remember that occurring was in the aftermath of the 9-11 attack. The markets were closed from the start of the assault until the following Monday. The futures were at limit down before the start of trading, as we recall.

The goal is to allow people some time to catch their breath and digest the information that initiated the rash of buying or selling. Cooler heads usually prevail. After the limit is lifted, trading may still be frantic but not out of control. This is especially important during a sell-off. The last thing the exchanges want is a panic-induced rush to the exits that sends prices into an irreversible tailspin.

How should you, the individual investor, respond if you flip on CNBC one morning and see the DOW or NASDAQ futures at limit up or limit down? Not much, in most cases. Trying to buy shares in a run-up or dump shares in a major decline will probably result in a poor fill or no fill and a nasty case of whiplash from a whipsawing market.

However, if you have good day trading tools you can attempt to play the inevitable reversals. The market always overreacts; when the DOW drops 100 or 200 points in short order, it will come back before resuming its decline. Buying and then quickly selling an index-tracking Exchange Traded Fund, or ETF, could net some nice profits.

The same goes when the DOW or NASDAQ blast higher. The indexes will likely pause and decline for a spell as individual stock traders take their profits. At that point, short selling an ETF like the DOW ?Diamonds? (DIA) or NASDAQ ?Qubes? (QQQ) should work. ETFs, unlike stocks, have a special advantage because they don?t require waiting for an ?uptick,? or rise in price, before filling a short sale.

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