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What Are Circuit Limits or Price Band

26 Jul 2023

Introduction

Investors often hear the term 'volatility' in relation to the stock market. Stocks trading on the market have a constant changes in their prices, depending on trading volumes, demand, and supply. However, sometimes certain shares can experience dramatic changes in their prices. The reasons for this could be many. That's where price bands and circuit limits come into play.

What Are Price Bands And Circuit Limits?

Price bands simply refer to a range of prices a stock is allowed to trade in before it hits a circuit limit. A circuit limit is a safety mechanism set up by the exchange to prevent dramatic movements at a stock price in a short time interval. Imagine what would happen if the price of a scrip fell by a whopping 40% in a single day? It risks wiping out investor wealth and could bring huge losses.

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A price band denotes a price range within which a share is allowed to trade. Once the share price reaches the upper or lower limits of this range, the price is locked and the stock is said to hit an upper or a lower circuit. Once a circuit is hit, trading stops, and the said asset cannot be bought or sold, depending on the kind of circuit. Circuit limits can range from 2% to 20%, depending on the volume, liquidity, and the kind of stock. You can use filters on the NSE website to find a list of stocks that have hit the circuit.

What Happens When Stocks Hit Circuit Limits?

When a stock hits an upper circuit, it is a result of high buying volumes that exceed selling volumes. In other words, when there are only buyers, the stock hits the upper circuit. The price is locked in the upper circuit band and it is not possible to buy it anymore. However, investors who owned the stock before it hit the upper circuit can sell it. The opposite is true for lower circuits. When a stock is at a lower circuit limit, there are only sellers. There are no buyers. Hence, trading is paused. 

What are the scenarios when stocks hit circuit limits?

There can be many factors behind stocks hitting upper or lower circuit limits. Some of these are:

  • Volatility: Highly volatile, small-cap stocks often have a 5% limit. Circuits, in this case, prevent abrupt fluctuations in their price movement.
  • Trading Volumes: Stocks can experience high trading volumes due to news, global tensions, political events, etc. Circuits give investors more time to think about their actions in these challenging situations.
  • Corporate Actions: Certain corporate actions, such as demergers or acquisitions, can make the price of a stock highly volatile and subject to a circuit limit.
  • Overall Market Conditions: The overall market sentiment (bullish or bearish) can drive stock prices dramatically. Circuit limits step in to prevent such quick gains or losses.

Why Are Circuit Limits Useful?

Although circuits limit the liquidity of a stock, it is done with the larger interest of benefitting investors. Here's why they are important:

  • Helpful against volatility- Circuits keep a stock within a certain price range within a certain time. This offsets huge losses to investors. As trading halts, investors have more time to think about buying or selling decisions.
  • Protects Retail Investors- Upper and lower circuits protect not only investor wealth but also help them against making wrong decisions. These are specifically helpful for small and mid-cap stocks. Small and mid-cap stocks are often very volatile, and sometimes even operator-controlled. Price bands play a significant role here.

Final Words

Circuits bands, as we learnt, are an important safety mechanism, put in place by the Securities and Exchange Board of India. Circuits prove helpful in mitigating risk by protecting investor wealth and allaying wild speculations. Circuits are often very important in cases of geopolitical events, bad news related to a particular share or political upheaval. In such cases, investors, especially retail investors, tend to make rushed decisions. Circuits help them think more clearly about their actions. They also allow time for more clarity on the trigger event that drives volatility in the first place.

 

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