What is the Upper and Lower Circuit in Shares?

Whenever one is going to invest in the stock market it comes along with its share of slang or technical terms and two such terms that come across frequently are the upper circuit and lower circuit These terms are very much useful and significant for those who are involved in short-term trading. In today’s blog post, I’m going to look at what these terms mean, why they have emerged, how they operate and the implications for investors.

What does the Upper and Lower Circuit represent?

The meanings of “upper circuit” and “lower circuit” are features implemented in the stock market to control the flapping of the stock prices. They are in effect price ranges approved by the stock exchange within which a given stock can transact in a given day.

Upper Circuit: The highest that a stock can trade at within a particular day to be permitted to continue trading. If a stock reaches it’s upper circuit, it implies that there is a limit on the number of points the price of a certain stock can move up to on a specific trading session.
Lower Circuit: The lowest permissible price level which may be traded in the stock exchange for a certain day. If it gets to the position whereby the stock is at the lower circuit, it then means that it has reached the lower most level under which it cannot trade for that particular trading day.

Both of these mechanisms are meant to afford equilibrium and reduce volatility within the stock market, which is often brought about by swelling speculation, information release or change in the attitude towards the market.

What Is the Purpose of having Upper and Lower Circuits?

This is the main role of upper and lower circuits so as to maintain high unpredictable swings in the stock market. Lack of control of such flounders often precipitates wrong decisions by investors, panic in the market or incurring severe losses. They act like a ‘circuit breaker’ and suspend trade whenever the prices rise or drop to certain specified levels to enable investors or traders to take informed decisions.

Here are some of the key reasons why these circuits are in place:

Market Stability: Price limits therefore basically mean that the hasty and rapid fluctuation of price in a particular stock is controlled by the stock exchanges. This keeps the general market in check and ensures that investors especially those in the retail segment are not exposed to high volatile prices.
Prevent Manipulation: Upper and lower circuits protect shareholders from the manipulations of spinning in which some traders may manipulate the prices up or down.
Time for Reflection: When the stock reaches either of the circuits, the trading of the particular stock may be suspended to afford investors to touch base and consider news or events that may cause them to make uninformed decisions.
Regulatory Compliance: Most stock exchanges around the globe especially the NSE and BSE in India or NYSE and NASDAQ in the United States are by the rules and regulation of the regulatory authorities to put in place circuit breakers to help in the control of the flow of shares and protect the investors.

What is the Mechanism of Upper and Lower Circuit?

More to the point, the upper and lower circuit levels are fixed by the respective stock exchange as per the previous closing price affected in a stock. They are often defined in respect to the closing price of the stock of the preceding trading session. For example for a given stock that closed at $ 100 the previous day the upper circuit limit is 10% then the upper circuit for that particular day will be $ 110, the lower circuit will be $ 90.

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Circuit Levels

Classification of stocks in the stock exchange is normally done depending on volatility, liquidity and market capitalization. Accordingly, different circuit levels may be set for different categories of stocks:

5% Circuit: In the case of those stocks, which are either very much risky and / or thin-traded.
10% Circuit: For moderately volatile stocks he will have to wait until the volatility either reduces or the price again goes up.
20% Circuit: Specifically, it is applied to less speculative, and more openly traded stocks.

Some of these stocks may experience a trading suspension which may last for a few minutes to even a few hours depending on the exchanges rules or the size of the movement. For instance, the NSE has put in place circuit limits that include 10%, 15% and 20% for Nifty 50 index in India. When the index goes high or low to such levels, the trading is suspended for a certain number of minutes.

Effectiveness of Upper and Lower Circuits for the Investors

The concept of upper and lower circuits is important to the investor most importantly for the short-term trader. Here are some of the impacts:

Limited Liquidity: When any particular stock reaches its upper or lower circuit then the companies have very less floatation. For instance, it is logical to state that if a stock has reached it upper circuit then it might be rather difficult to look for sellers who are willing to sell the stock at such a price. Likewise, if a stock comes down to its circuit filter, it can be difficult to locate a buyer for the stock. This may results in positions being locked until the market is open again.
Market Sentiment: Meanwhile, the upper circuit is considered as a bullish signal while the lower circuit as a bearish signal. However, this is not ends with this because such movements can often be achieved through speculation instead of solid grounds.
Trading Opportunities: To the experienced traders they may find upper and lower circuits as an opportunity for trading. For instance, if the trader expects the stock to go up to its upper circuit, he is free to buy on anticipation of selling after the price has risen a bit. On the other hand they might short sell a stock that is expected to sink to the lower circuit.
Risk of Losses: As much as circuits serve to limit losses and protect the investors, they are actually circuits the opposite for retail investors. Even in cases where a stock reaches its lower circuit for several consecutive days, there could this mean a lot of loses in case the investors cannot sell. Likewise, the stocks making upper circuits can fetch a capital which could be helpful at other place.

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Conclusion

The upper and the lower circuit are essential to ensure that prices within the market are kept constant least they go higher or lower than the probably set limits. They saves investors from fraudulent activities and stock market crash, offer a buffer period in volatile markets, and offers an orderly trading mechanism. To the stock market investors, it is crucial to get a basic notion of how such circuits operate, for which reasons, and with what consequences.

Mr Patel also went on to explain that the challenges and opportunities that the hitting upper or lower circuits pose to investors can be contained through education, diversification and proper risk management.

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