Understanding What Are Upper Circuit And Lower Circuit In Stock Market: Every investor in the stock market desires to earn significant returns from the market. Investor participation increased multi-fold after COVID-19. In the securities markets, volatility gets associated with huge swings in either direction.
For example, when the market rises and falls by over 1% over a sustained period of time, it is termed a “volatile” market. Regulators have done their best to manage volatility and protect investors’ interests and one of them includes setting circuits. Today we will take a look at What Are Upper Circuit And Lower Circuit In Stock Market?
What Are Upper Circuit And Lower Circuit?
Upper circuit and lower circuit in the stock market was introduced by SEBI to protect the investors’ capital to some extent. In the basic form, they are emergency-use regulatory measures. They temporarily halt trading on exchanges. This is particularly important to manage panic-selling, and they can also get triggered when there is strong buying.
They can be used for individual securities and market indexes. They function automatically and halt trading when prices touch predefined levels in exchanges. In markets, there are 2 types of circuit filters: one focuses on stocks, while the other is market-wide. This explainer will focus on both stock-level and market-wide circuit filters.
Upper And Lower Circuits For Individual Securities
Now that we have understood What Are Upper Circuit And Lower Circuit In Stock Market, Let us now discuss the various circuit limits for individual securities. To protect investors from a significant single-day reactive share price drop or rise, stock exchanges set a price band every day. This is based on the last traded price of the individual security.
As the name dictates, the upper circuit refers to the highest possible price that particular individual security can trade at on that day. On the contrary, the lower circuit means the lowest level that the stock price can trade at on that given day.
Use of upper circuit and lower circuit in stock market is purely a move focused on protecting the investor from incurring significant losses. Limit can be set at a figure and is represented by a percentage. It can be between 2% and 20%.
You might have thought of picking up a stock which helps you get 50% or 100% return in one day. Sadly, this might not be possible because of the circuit limits beyond which price of the stock cannot move. Stocks that several individuals want to buy but barely anyone is selling can hit the upper circuit.
There can be multiple reasons for such increased demand including strong results, launch of a new product, insider buying, etc. Upper circuits are assessed on the basis of previous day’s closing price. Upper circuits may have different percentages for different stocks.
While there are stocks having upper circuits at a price 2% higher in comparison to their previous day’s closing price, other stocks may have their upper circuits at prices 5%, 10%, or 20% higher than the previous closing price. However, the circuit might open if some people decide to book profits and start selling their holdings.
Lowest level to which a price of stock can fall is called the lower circuit. This is possible if there are more people selling the stock rather than buying it. Lower circuits are calculated on the basis of previous day’s closing price.
For some stocks, it might be 2% lower than the previous day’s closing price, while for others the circuit might be 5%, 10%, or 20% lower. When there are fewer buyers of a stock, its price might decline. Fear of investing money in a stock that is already falling can lead to further decline. To prevent this, lower circuits have been placed.
Market-Wide Upper And Lower Circuits
Upper circuit and lower circuit in stock market may be used not only for individual securities but are implemented for an index too. Circuit breaker system raises a red flag and warns if an index either falls or rises by 10%, 15%, and 20%. In India, if this situation takes place, trading gets halted not only in equity markets but also in the derivatives markets. Halt might last for a few minutes or for the remainder of the trading day.
Individual Stocks Hit Their Circuits – What Can Be The Reasons?
Individual security might hit the circuit as a result of several reasons. For example, due to positive news flow, there can be a huge demand for the stock of a particular company. As a result, the stock can hit the upper circuit. Likewise, there is a possibility of an opposite scenario if there are adverse news flow. Following is important in case of circuits:
Higher demand than supply – Upper Circuit
Higher supply than demand – Lower Circuit
Circuit filters are revised on the basis of volatility present in the market or any unusual activity in certain shares. However, these filters are also revised periodically due to market liquidity. To put things into perspective, circuit filters are hiked for stocks which have good liquidity and they are lowered for illiquid stocks.
A stock can touch its circuit limits if an event which can change its desirability takes place. However, change in desirability should be very high for stock to touch its upper or lower circuit. Sometimes market manipulation can also cause stocks to hit upper or lower circuits.
Circuit filters help in regulating price fluctuation in a day and they tend to act as market curbs whenever there is panic selling or strong buying. At times, these filters can help in reducing price manipulation by stock operators.
Upper circuit and lower circuit in stock market have been placed solely to protect investors from losing their invested amount. Circuits not only help in protecting investors’ capital, but they also represent a red flag for some companies.
Some individuals consider the circuit of a stock when they do predictions about the movement in prices. However, investors should not make trades solely on the basis of securities or indices hitting their upper or lower circuits.
Due to the recent pandemic and lockdown conditions, Sensex fell by 10% and NIFTY50 plunged by over 9% on Mar 23, 2020. As a result, trading on these exchanges was halted.
While market circuit breakers help in stopping the volatility, they cannot avoid the fall. On Mar 13, 2020, a similar situation was seen when the markets hit their lower circuit breakers. Therefore, upper circuit and lower circuit in stock market help investors in these untimely events.
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