Imagine waking up to find that a stock you own has fallen the maximum permitted amount and no buyers are available. You cannot sell even if you want to. This unsettling experience is the result of circuit filters, which exist to prevent extreme price swings in a single session. Whenever an investor follows the BSE Share Price of a volatile small company, the circuit band attached to it is as important as the quote itself. The same applies when tracking the NSE Share Price of a stock under surveillance. This article explains how circuits work, why they are applied, and how to protect yourself from being trapped.
What Circuit Limits Actually Are
A circuit limit is basically a percentage band within which a stock can rise or fall on a particular day. The range varies from two to twenty per cent depending on the volatility of the stock and the assessment done by the exchange. Once the share hits the upper limit, no more sales can happen at higher prices. Likewise, if it touches the lower limit, no selling can happen below it. The stock in this scenario gets frozen and there are orders stacked on one side with little trade happening at the other end.
Reasons Why They Exist
The rationale behind circuit breakers is to prevent panic and rigging. In the absence of limits, a rumour about corporate action could propel or dash the price of a thinly traded stock by fifty per cent in one day. The circuit band thus allows the market to absorb information and prevents a few large players from skewing the price of a stock. Besides the circuit limit for specific issues, there are also circuit breaks for indices. This is mainly to curb rampant selling or buying of a basket of shares in a single day. The thresholds are set at different levels by regulators and, when breached, result in halting trading for some time. This is a rare occurrence but offers a much-needed relief interval.
The Most Dangerous Scenario for Investors
The most dangerous scenario is when a stock gets locked in the lower circuit. Since the sell pressure far exceeds supply, any sell order cannot be executed for days. This can be extremely detrimental especially for weak stocks. This happens most commonly with small caps with low liquidity. A lot of investors get caught napping when a company they invested in announces some negative news like delayed filing of results or change of auditors or regulatory action against the company. The position size becomes very important in such scenarios. A large position in a single stock with low liquidity can cripple an investor.
How an Investor Can Protect Himself
An investor must always check out the circuit limit and volume of a small cap stock before buying. If the volume is not satisfactory, he should think twice or not buy at all. Secondly, he must always limit the size of his position in such stocks to maybe five or ten per cent of his overall portfolio. It is better yet to invest in stocks which have good disclosures, consistent results and competent management. Lastly, investors should not get carried away when a stock opens at the upper circuit. Many investors who bought at the closing price often regret having done so since the market often reverses sharply on the next day.
The Bottom Line
A circuit limit basically controls the tempo of a stock price. It does not dictate its value. An investor must understand the importance of cash flows and earnings of a company in determining its true value. Circuits are just there to provide him with a pause/clutch to think and reassess the situation. Investors who ignore liquidity, overconcentrate and extrapolate trends are the ones most likely to get caught in a short circuit.