Concept of Circuit Limit
Published by Sharekhan Education | May 4, 2021
Concept of Circuit Limit
Stock prices often behave irrationally and over-react to the news. The circuit limit is used by stock exchanges around the world to curb the excess volatility in the market. Circuit limit is the maximum movement allowed by the exchange for a particular stock or indices in both the direction. When the price moves above or below the limit, trading is halted on the stock.
Upper Circuit is the limit above which a stock price cannot trade on a particular trading day. For example: suppose, if the stock has an Upper Circuit Limit of 20%, the stock can move a maximum of 20% on the upside. Let us assume if a stock closes at Rs 100 on the previous day. Then the upside of 20% on 100 is 120. So on the next day, if the stock moves up, it can move up to a maximum Upper Circuit price range of Rs 120.
Lower Circuit is the limit below which a stock price cannot trade on a particular trading day. For example: suppose, if the stock has a Lower Circuit Limit of 20%, the stock can move a maximum of 20% on the downside. Let us assume if a stock closes at Rs 100 on the previous day. Then 20% downside on 100 is 80. So on the next day, if the stock moves down, it can move at a maximum Lower Circuit price range of Rs 80.
Limit set for Indices:
SEBI has set circuit limits at 10%, 15%, and 20% for the indices. If the 10% limit is hit, trading can be halted between 15-45 minutes depending on the time of the breach. The 15% limit leads to a halt in trading for 45-75 minutes, while the 20% limit leads to the closure of markets for the rest of the day. The key price bands applicable to stocks are 2%, 5% & 10% depending on the need to contain volatility beyond acceptable levels. The exchange determines daily price bands or circuit limits for all the listed stocks. No price bands are applicable on stocks for which derivative products (F&O contracts) are available.
Advantages of Circuit Limit Rule:
A circuit limit lets the market cool down. The halt time helps the traders to go through the announcements and news so they get acquainted with facts before planning their next trade. It avoids panic situations and overwhelming reactions by traders.
Disadvantages of Circuit Limit Rule:
A circuit limit prevents real-time price movements that do not allow the discovery of real-time pricing during the market halt. Some traders may get early access to the news before the circuit limit kicks in and they might take advantage of it. Whereas, others who do not get any circuit limit news, might end up in loss.
Summary:
In essence, circuit limits or price bands for indices and stocks serve as a risk protection mechanism for the markets overall, especially for retail investors.
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