Several of Adani group stocks started hitting their lower circuits in June 2021. As many new investors watched knowing not what to do or expect, trading was halted in order to inhibit any potential manipulation of the stock prices.
It might have felt like a punishment for a lot of investors, but the move was actually an investor protection measure.
Circuit breakers, set in place by SEBI, could be referred to as a volatility safeguard for investors. Let’s find out what they are and how you can use them.
What is upper circuit/ lower circuit?
Let’s divide our discussion into two parts. Upper and lower circuits for stocks, and upper and lower circuits for indices.
Upper and lower circuits for stocks
In order to protect investors from a drastic single-day reactive share price drop or share price hike, the stock exchanges set up a price band everyday, based on the last traded price of the stock. The upper circuit is the highest possible price that the stock can trade at on that designated day. The lower circuit, as you may have guessed, is the lowest that the stock price can trade at on that day.
The use of upper/ lower circuits in the stock marketis purely an investor protection move.
The limit may be set at a figure – represented by a percentage – as determined by the stock market. It may be anywhere between 2% and 20%.
For example:
Stock A trading at Rs 100 per share today has a 20% circuit. That means that the share price cannot drop by more than 20% and also cannot increase by more than 20% in the trading session. During the day, even if the company finds a gold mine beneath it’s office premises, the price will only vary between Rs 80 and Rs 120.
Upper and lower circuits for indices
Circuits may be used not just for individual stocks, but may also be implemented for an index. The circuit breaker system raises a red flag when an index either dips or rises by 10%, 15% and 20%. When this happens, trading is halted not just in equity markets, but also in the derivatives markets in India.
The halt can be for a few minutes or it might last for the remainder of the trading day. It depends on the percentage of the rise or fall in the index.
10% rise or fall
If an index rises or falls by 10% after 2.30 pm, nothing really happens. One can probably attribute this to typically higher volatility at the end of the trading day.
A 10% rise or fall between 1:00 pm and 2.30 pm activates a 15-minute pause in trading activity.
However if it rises or falls by 10% before 1 pm, a 45-minute halt in trading activity is set off.
15% rise or fall
If there is a 15% rise or fall in the index after 2.30 pm, then trading activity is halted for the remainder of the trading day.
If an index rises or falls by 15% anytime between 1:00 pm and 2:30 pm, it results in trading activity being halted for 45 minutes.
If it rises or falls by 15% before 1:00 pm, a 1 hour 45-minute halt in trading activity is enforced.
20% rise or fall
Trading activity is ceased for the day if at any point, an index marks a 20% rise or dip.
1. Circuit filters are applied on the previous day’s closing price
2. You can find the circuit filters on the stock exchange’s website.
3. Stocks most commonly start with a 20% circuit.
4. If a stock hits its upper circuit, there will be only buyers and no sellers; similarly, if a stock hits its lower circuit, there will be only sellers and no buyers in the stock.
5. In such cases, intraday trades are converted to delivery.
How to use circuits or price bands on stocks to your advantage
If you are an amateur trader it is best to avoid stocks that frequently hit their circuits or stocks that display very frequently revised circuits – this is a clear sign that the exchange is concerned about trading activity linked to these stocks and therefore a red flag for you.
If you have already invested in a stock, it is best to exit when you see the circuit heading towards 5% and lower. Very little volatility usually also corresponds to low earnings potential.
Conclusion:
In case of sudden swings, investors stand to lose sizable capital. This is why circuit breakers have been put in place, to protect the investor from unwanted surprises. Circuits can not only protect you but also represent a red flag for some companies. Consider the circuit of a stock while making your price movement predictions.
