The why and how of circuit limits

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Limit your movements.
Limit your movements.

When the markets go beyond a specified limit within a short span of trading time, circuit limits are brought into operation to restore a sense of sanity.

K. Venkatasubramanian

Earlier this week, history was made by the Indian stock market as a euphoric reaction to the Congress-led UPA winning the elections. It was a ‘golden Monday’ or so investors proclaimed.

Trading in the bellwether indices — Sensex and Nifty — had to be halted because they had run up by over 10 per cent within a matter of seconds. When trading resumed a couple of hours later, there was another surge in the markets, resulting in trading being halted for the rest of that day.

Why was trading not allowed to continue? Why are circuit limits imposed in markets? What are the guidelines in imposing a circuit limit? This article attempts to answer these questions and look at some past instances when limits were imposed.

Circuit breaker

Consider the analogy of a circuit breaker or a fuse in the electrical switch board in your house. The moment there is a sharp surge in current that is higher than what an appliance can withstand, the fuse or circuit breaker cuts off the supply to prevent a breakdown.

Similarly, when the markets go beyond a specified limit within a short span of trading time, circuit limits are brought into operation to restore a sense of sanity. This is true of individual stocks and broader markets.

This halt in trading makes stakeholders take stock of what is happening before buying or selling stocks. This is done to tone down trading decisions based on irrational exuberance or overtly pessimistic reaction towards any development at the macro-economic, market, or company levels.

Though no stock on the Sensex or the Nifty has a circuit filter, SEBI has mandated a market-wide circuit for 10, 15 and 20 per cent movement (upward or downward) in either of these indices. The following are the guidelines for imposing circuit breakers.

If there is a 10 per cent movement in either index within 1 p.m (trading starts at 9.55 a.m.), a one hour halt in trading is imposed. In case the movement takes place after 1 p.m but before 2:30 p.m., there will be a trading halt for 30 minutes.

But if this level is crossed after 2.30 p.m., there is no circuit limit for the rest of the day. For a 15 per cent movement in either index, trading is halted for two hours if it happens before 1 p. m.. If the 15 per cent level is breached after 1 p.m. but before 2 p.m., one hour stoppage in trading is implemented.

But if it happens after 2 p.m, trading is halted for the rest of the day. For a 20 per cent movement in either index, the trading will be stopped for the rest of the day.

Percentage calculation

There is another finer point in this circuit breaker calculation. The percentage is calculated on the closing value of the Sensex or the Nifty on the last day of the immediate preceding quarter.

So for determining the circuit limit for the April-June 2009 period, the closing value of the bellwether indices on March 31, 2009 would be used. The Nifty had closed at 3020.95 points on March 31. So on May 18, when the markets opened, the 15 per cent circuit was hit within a matter of seconds as the index gained 532 points. This happened even before a 10 per cent circuit could be applied.

When trading resumed a couple of hours later, again within seconds, the 20 per cent circuit was hit and trading was halted for the rest of the day.

How can the index open with such a huge ‘gap up’? If a stock A is quoting at Rs 100 after the day’s trading in one of the indices, and the on the next day if you would like to buy the stock, you would put in bids.

In normal times, that would be close to Rs 100, say Rs 101-102. But if investors put in first bid in the morning at Rs 120 due to irrational expectations and this pattern is repeated across most stocks, or those with higher weights in the index, then the index surges ahead!

During this curtailed trading session only 847 stocks of the usual 2500 on BSE were traded while on NSE only 207 of the 1,300 stocks were traded.

Other than investors who already held to stocks that went through the roof on that day, others may have been denied participation in this rally.

Past instances

There have been previous occasions when the circuit breaker has been invoked; mostly when markets fell. On May 17, 2004, the Sensex crashed 550 points within 20 minutes of opening resulting in the application of the 10 per cent circuit breaker.

When trading resumed, it had to be closed within minutes after losing another five per cent, triggering the next filter.

This was in reaction to the NDA, which was expected to win the general elections, losing out to the UPA (with the support of the Left parties), which was deemed a big negative for the markets. On January 22, 2008 and October 17, 2007 the 10 per cent downside circuit was hit during the course of trading.

But on both these occasions, trading did continue in a normal fashion and no further circuit breakers were triggered.

(This article was published in the Business Line print edition dated May 24, 2009)
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