How Are Circuit Limits Applied in the Stock Market?

What Are Circuit Limits?

The circuit limit is a regulatory mechanism that sets predefined thresholds for the stock price movements. These price thresholds are defined by the stock exchanges to regulate the maximum permissible upward and downward movement of the stock price for a single trading session. The overall aim of the circuit limits is to minimize the excessive stock price movements during volatility and maintain stability in the financial markets.

As soon as a stock reaches its predefined price band, the trading behavior of the stock changes according to the applicable rules. Such that, for an individual stock level, further movements in the stock price beyond the limit become restricted. Moreover, in case of broader market movements, the market-wide circuit breaker stock market rules might help in temporarily halting the trading process across the listed securities. 

In India, the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) implement the stock circuit limit regulations in accordance with the regulatory frameworks that are designed by the Securities and Exchange Board of India (SEBI).

The percentage limit assigned to a stock for upward and downward price movements depends on several factors, including:

• The liquidity of the stock
• The historical price volatility of the stock
• The trading volumes
• And the regulatory classification provided by the stock exchange.

These parameters decide the stock circuit limits, such as 2%, 5%, 10%, or 20%. However, in the case of derivates-eligible stocks, the price control mechanism may vary. Instead of imposing a strict daily cap, an initial dynamic price band serves as a preliminary control.

Upper Circuit vs Lower Circuit

To achieve control over the excessive market volatility, the stock exchanges impose circuit limits in the form of predefined price bands that have upper and lower circuit limits.

What is Upper Circuit?

An upper circuit represents the maximum price at which the stock can be traded during a particular trading session. Factors such as positive news related to the company, increased purchase demands with limited sellers, and a sudden increase in speculative interest contribute to upper circuits. That means when there is an excessive buying pressure on the stock, and the price reaches the upper limit:

• The trading for that stock will be temporarily halted. 
• Additional purchase orders may accumulate.
• Trading will continue only if the seller continues the transaction for the stock at the upper circuit price.

For example, if a stock closes at ₹500 in the previous trading session and is defined by a 10% upper circuit limit, then the maximum price the stock can rise according to the upper circuit limit is ₹550. The trading for this stock will not take place above ₹550. 

What is Lower Circuit?

A lower circuit is the minimum price a stock will reach during the trading session. Factors like fraud allegations, regulatory issues, weak financial results, global downturn sentiments, or any negative news about the company can make a stock reach its lower circuit limit. And as soon as the stock reaches its lower limit:

• Any further price decline in the stock price is restricted.
• The sell orders may continue to accumulate.
• The stock may observe limited buyers until the market sentiment for the stock improves.

For example, if a stock closed at ₹800 in the previous trading session and has a 10% lower circuit limit, then the stock cannot be traded below ₹720 during a trading session. 

Why Circuit Limits Are Applied

Extreme price swings in stock prices can impact investment decisions. That’s why stock exchanges impose circuit limits depending on the market volatility, surveillance categories, and liquidity. Here are some of the critical situations where circuit limits play an important role:

Keep Control of the Price During Excessive Volatility

The geopolitical developments, global economic events, and unexpected corporate announcements can lead to emotional buying and selling of stocks. Circuit limits help in preventing the extreme price fluctuations that might occur too quickly.

Minimize Panic Driving Trading 

Stock investments can be driven by panic-based decisions during unexpected high or low stock prices. Stock circuit limits can provide additional time to investors to evaluate the developments in the stock prices.

Maintain Market Stability

Circuit limits maintain orderly trading conditions with a predefined upper and lower circuit limit. This promotes stability in the investment markets and inspires investor confidence. 

Instead of interfering with the everyday stock market activities, the circuit limits make sure that the price movements remain within the defined limits, especially during the periods of heightened uncertainty.

Stock-Level Price Bands

All listed companies might not have the same stock circuit limits. Stock exchanges may assign different price bands depending on the risk profile and the security trading characteristics of the company.

The following daily price bands are applicable to securities as defined below:

• Daily price bands of 2% (either way)
• Daily price bands of 5% (either way)
• Daily price bands of 10% (either way)
• No price bands are applicable to scrips on which derivative products are available.
• Price bands of 20% (either way) on all remaining scrips (including debentures, preference shares, etc)
• Scrips on which no derivate products are available but which are part of Index Derivatives are also subjected to price bands.

These applicable price bands are periodically reviewed by the exchanges depending on the objective criterias.

Index-Based Market-Wide Circuit Breakers

Unlike the stock circuit limits that are applied to individual securities, the index-based market-wide circuit breaker stock market mechanisms are designed with a goal to protect the entire stock market in situations of extreme volatility. Rather than restricting the price movements of individual stocks, these market-wide circuit breakers temporarily halt the complete trading process across all the defined securities when sharp movements are observed in benchmark indices.

In India, the movement of the Nifty50 and BSE Sensex benchmark indices can trigger market-wide circuit breakers. If either of the indices sharply moves by a defined percentage from the previous day’s closing level, the complete trading across the equity and equity derivatives markets might be suspended for a specified period.

In simple words, the market-wide circuit breakers help by:

• Preventing the panic-based buying or selling.
• Giving investors the cooling-off periods to analyze new information.
• Maintaining orderly market conditions.

Note that market-wide circuit breakers are activated only during unexpected market conditions and are relatively rare as compared to stock-level price bands.

10%, 15% and 20% Circuit Breaker Rules

The Indian stock market typically follows three thresholds for a market-wide circuit breaker. These thresholds are calculated depending on the movement of the benchmark index from the previous day’s closing value.

What Happens When a Stock Hits Circuit?

When a stock hits the stock circuit limit, the exchange will temporarily halt its trading to prevent panic investments or excessive volatility. However, the overall trading behavior will depend on whether the stock has reached the upper circuit limit or the lower circuit limit.

If the Stock Hits the Upper Circuit

A stock hitting the upper circuit indicates an overwhelming interest from the investors. In such situations, the demand may drastically exceed the supply, and only the buy orders are allowed to be placed. In addition, these buy orders will continue to accumulate since the transaction will occur if the seller is willing to sell the stock at the upper circuit price.

If the Stock Hits the Lower Circuit

A stock hitting the lower circuit reflects intense selling pressure. In this situation, only the sell orders continue to queue up, since the buyers might be unavailable, thus making it difficult for investors who want to exit their position.

Note: Upper circuit lower circuit simply indicate the unusual buying or selling situation during a particular trading session; it does not indicate whether a stock is fundamentally weak or strong.

Risks for Traders and Investors

While circuit limits are designed to stabilize the stock price movements during market volatility, they do introduce significant risks for traders and investors:

• Decreased Liquidity: As soon as the stock hits its upper or lower circuit, it gets locked at that price. Now, if at this stage an investor gets stuck on the wrong side, it might get difficult to exit the position as there might not be any buyers or sellers available at matching prices.
• Gapping and Order Rejection: Exchange might reject orders that are placed outside the day’s permissible price band. Similarly, unexpected news may open a stock at a new session on a new circuit limit, leaving investors trapped at a significant loss.
• Limited Stock Entry Opportunities: When the stocks continuously remain locked at the upper circuit, the investors may miss out on buying opportunities due to a shortage of sellers.