Analysis of this phenomenon has convincingly demonstrated its validity and value as an ancillary trading tool in futures with limits on permissible daily price ranges. Especially in dynamic markets wherein so much opportunity and emotion exist, understanding and applying its principles can profitably supplement any trading technique.
Robert Howe, market technician and analyst, first offered this observation to us in 1977. Howe's Limit Rule simply suggests that a price at the limit of a tradable daily range, once reached, becomes an objective which the market will again test and ultimately exceed, at least briefly and usually sooner rather than later.
Why? A primary function of any market is to explore and discover value. A market artificially interrrupted in its pursuit of current value is unsatisfied and leaves critical questions, such as how far and how urgently the market would continue searching, unanswered prior to further trading activity.
Value and Utility
Unlike objectives derived from chart formations and mathematical formulae which, at best, approximate a target range, Howe's Limit Rule identifies precise price targets which can be valuable to both short-term and position traders.
For instance, if a market trades at a "limit up" price:
- short-term traders may more confidently buy into any pullback (whether intraday or during subsequent trading days);
- traders already long may be encouraged to maintain their positions;
- prospective short-sellers may be discouraged from taking immediate action and wait until the price level is exceeded.
Understanding the principles of Howe's Limit Rule, each of the above would expect a decline, if any, to be minor unless and until that limit price is exceeded by at least one tick.
However, if after a prolonged trend a limit price is exceeded only briefly and tentatively, a failure that ultimately constitutes a reversal may be imminent (as the market exhibits exhaustion). As a corollary, an unexpected limit move in the direction opposite the prevailing trend can be an early warning of a trend reversal (as everyone changes their minds at the same time). Finally, an abrupt limit move from out of accumulative or distributive congestion can signal the beginning of a powerful new trend (as everyone tries to go through the same door at the same time).
On the rare occasion when a lead contract leaves a traded limit price "hanging" (not exceeded prior to its expiration), that limit price is carried over as a future objective for subsequent lead contracts. As such, it can become a magnet for intermediate- or long-term trend exhaustion. In other words, the prevailing trend may be maintained and/or a new trend suppressed from beginning until that "hanging" limit is exceeded, often creating a double top or double bottom.
Why? The lead contract is most cash-connected and used on weekly/monthly charts. Hanging limits on nearby contracts often become significant support/resistance points on weekly/monthly charts. Limits left hanging in deferred contracts are specific to them only and usually become irrelevant at expiration.
Analysis, Conclusions, Howe's Open Limits
Moore Research Center, Inc. has statistically evaluated limits traded, exceeded, and hanging in certain markets in which daily trading limits remain established. That analysis implies the key historical significance of the first and third days immediately following a trade at a limit price. In a majority of those markets, as one might expect, a limit-traded price has been exceeded on the first day following 50-70% of the time. In almost all markets studied, the analysis suggests the historical probability of exceeding a limit price is often greater than 80% within 3 trading days, and 90% within 7 trading days.