Everyone must be familiar with the electric circuit breaker in our houses. Their main purpose being to protect the device from overload or excess electric current by stopping the flow of electricity to the devices.
Circuits in markets act the same way by acting as emergency pause button when there is excess volatility and panic-selling and temporarily halting the trading to keep markets from free falling.
Ever wondered how the market responds to volatility due to some news, results of the companies or due to the global pandemic COVID-19? Due to increased volatility in markets, the most affected people are the retail investors who are last ones to react to the new information in the market. To avoid the erosion of capital, SEBI has incorporated price ranges and circuits.
Circuits essentially play the role of reducing the volatility in the markets and allowing the investors to think upon and act rationally.Indian markets hit the lower circuit for the first time after 2008 crash wherein the trading activities were halted due to massive dip in SENSEX ( down by 9.43%) and NIFTY(10.07%) on MARCH,13 mainly due to panic and rising worries regarding the outbreak .
There are two types of circuits in markets-
a) UPPER CIRCUIT: Maximum price limit which a stock can hit during intra-day.
b) LOWER CIRCUIT: Minimum price limit which a stock can hit during intra-day.
The price band is the range within which the scrip can be traded without being halted. SEBI has prescribed price bands which are applicable to all stocks ranging from 2% to 20% from their previous close. The essential difference between the two is that while circuit filters (or circuit breakers) pertain to the overall indices (Nifty and Sensex), price bands pertain to individual stocks.
Orders placed out of the price band will be rejected, and if the price drops to the upper/lower price band trading will temporarily be halted. F&O stocks have dynamic price bands in order to prevent erroneous order placement.To prevent members from entering orders at fake prices in such securities, the exchange has fixed an operating range of 10% on the trading terminal.
The index-based market-wide circuit breaker system applies at three stages of the index movement, both ways. These circuit filters apply at 10%, 15%, and 20%.
When these circuit breakers are triggered, it will result in a trading halt in all equity and equity-based derivative markets nationwide.This means that if the index crosses its first stage of 10% (either upside or downside), the trading will halt in the entire country i.e. no trading will take place on NSE and BSE.
From that point, you can neither trade in the cash market nor in the F&O market. The market-wide circuit breakers are triggered by movement of either the BSE Sensex or the Nifty 50, whichever is breached earlier.
Source : NSE INDIA
What happens after the trading halt duration is over?
After the circuit is breached, the market re-opens after index based market-wide circuit filter breach, with a pre-open call auction session of 15 minutes post the duration of halt. The normal trading could begin and continue as long as the next circuit limit does not activate.
Why are Circuits so essential?
Circuits tend to help investors from incurring huge losses and also prevent speculations in the market. The lower limit ensures that stock price doesn’t fall below a particular level and erode the entire capital of the investor. Suppose you purchased a stock X for say Rs. 100, 10 years before and the stock currently is trading at Rs 500/- , due to some news if the stock starts falling down, it is the lower circuit which protects the wealth of a long term investor and prevents the stock price from falling drastically .In a nutshell, price bands for stocks and circuit filters for indices are designed as a risk protection mechanism for the markets in general and retail investors in particular.