Futures price limit moves as options

Abstract

This note demonstrates that an asset's price in an environment with price limit rules can be replicated by the price of a portfolio consisting of a riskless asset and two synthetic options. A procedure is developed to unbundle the unobservable option values imbedded in the actual futures price and impute a theoretical true futures price. Using this framework, evidence from the Treasury Bond futures market suggests that theoretical true futures prices diverge from actual futures prices, on average, 3 h prior to the activation of price limit rules, indicating that price limit moves might 902 Holder, Ma, and Mallett be predictable. The reversal of both the actual futures prices and the theoretical futures prices back within the limit range after a limit move provides support for the possibility that traders tend to overreact when market prices are near price limits.

The magnet effect of price limits: A logit approach

“…In futures markets, Arak and Cook (1997), Berkman and Steenbeek (1998), and Hall and Kofman (2001) find no magnet effect, whereas Holder et al (2002) and Belcher et al (2003) find evidence of it. Results from stock markets also conflict: Cho et al (2003) and Nath (2003) find support for the magnet effect, but they cannot explain theoretically why it occurs only when the price approaches the upper limit (Cho et al, 2003) or the lower limit (Nath 2003).…”

What Makes Circuit Breakers Attractive to Financial Markets? A Survey

“…However, two other studies use a different approach and find support for the magnet effect. Holder, Ma, and Mallett (2002) show that an asset's price in an environment with price-limit rules can be replicated by the price of a portfolio that consists of a risk-less asset and two synthetic options. In other words, the futures price movement is equivalent to that of a portfolio that consists of a long position in the risk-less asset for the amount of the discounted difference between the previous closing price and the limit size, a long position in a call with the strike price equal to the lower limit price, and a short position in a call with the strike price equal to the higher limit price.…”

Are Price Limits Effective? Evidence From the Istanbul Stock Exchange

“…Kodres (1993) investigates this issue by modeling the volatility around limit events. Holder, Ma, and Mallett (2002) and Chance (1994) show the reversal of futures prices after limit move by using an option‐based model, and Chen (1998) finds little evidence to support the overreaction hypothesis in futures markets. On the other hand, Chung (1991) in Korea, Chen (1993) in Taiwan, Kim and Rhee (1997) in Tokyo, Phylaktis, Kavussanos, and Manalis (1999) in Greece, and Bildik and Elekdag (2004) in Turkey find no evidence that price limits reduce volatility.…”