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.
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.
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.
There can be many factors behind stocks hitting upper or lower circuit limits. Some of these are:
Although circuits limit the liquidity of a stock, it is done with the larger interest of benefitting investors. Here's why they are important:
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.