What Are Circuit Filters/Limits And How Are They Used?

In stock market parlance, two words are normally confused with one another: circuit filters and price bands. The essential difference between the two is that while circuit filters (or circuit breakers) pertain to the overall indices (Nifty and Sensex), price bands pertain to individual stocks. Therefore, individual stocks have price bands, while indices have circuit filters. That is the key distinction between the two. Before getting into the nuances of circuit filters and price bands, let us understand why exactly we need these filters.

Why circuit filters and price bands?

A price band is the limit beyond which the price is not allowed to move on a particular day. For example, you may have seen stocks locked in 5% upper circuit or in 10% lower circuit. We recently got to see this quite frequently in stocks such as Vakrangee, PC Jewellers, and Manpasand Beverages. Had it not been for price bands, these stocks could have resulted in tremendous value destruction. Here are four reasons why price bands and circuit filters are essential.

Price bands typically avoid vertical corrections in the stock. Most small and retail investors tend to buy stocks in the mid cap and small cap space. These stocks are more vulnerable to wild gyrations, either ways. These circuit filters are meant to provide protection to these small investors against big losses.

Stocks that approach their price band limits with volumes are a signal of likely stock price movement and traders can be pre-warned and take action accordingly. It, therefore, acts as an early warning signal for traders.

It gives the regulator a basis for looking into the price movement of stocks that are showing peculiar trends. This is more so of stocks that are consistently in upper price band or in lower price band limits.

Finally, index-wide circuit filters are useful in maintaining sanity and a semblance of order in the market. Traders who have been in the markets for more than decade do remember the lower circuits of May 2004 and May 2006 as well as the upper circuits of May 2009. It was only circuit filters that saved the day for the markets from going haywire. This can avoid an unwarranted sell off in the markets or situations where retail investors end up buying at steep valuations.

How price bands on stocks function in the Indian markets

The exchange determines daily price bands for all the listed stocks based on the previous day’s closing, and the price bands can be known on the trading system itself. The following are the key price bands applicable to stocks depending on the need to contain volatility beyond acceptable levels.

• Daily price bands of 2% (either way)
• Daily price bands of 5% (either way)
• Daily price bands of 10% (either way)
• No price bands are applicable on scrips on which derivative products (F&O contracts) are available. However, stocks on which no derivatives products are available but are part of any index on which derivatives are available are subject to price bands. This is a shift from the previous practice.
• Price bands of 20% (either way) on all remaining scrips (including debentures and preference shares).
• For the auction market, price bands of 20% are applicable.
• To prevent members from entering orders at fake prices in such securities, the exchange has fixed an operating range of 10% on the trading terminal.

How market-wide circuit breakers protect the market in general

The exchanges implemented index-based market-wide circuit breakers with effect from July 02, 2001. This was part of the major slew of stock market reforms initiated by SEBI after the Ketan Parekh scam that surfaced in the Indian stock markets.

The index-based market-wide circuit breaker system applies at three stages of the index movement, both ways. These circuit filters apply at 10%, 15%, and 20%. Circuit breakers, when triggered, bring about a coordinated trading halt in all equity and equity derivative markets nationwide. From that point, you can neither trade in the cash market nor in the F&O market. The market-wide circuit breakers are triggered by movement of either the BSE Sensex or the Nifty 50, whichever is breached earlier.

The table below captures the operation of the market-wide circuit filter:

Both the BSE and the NSE compute the index circuit breaker limits for 10%, 15%, and 20% levels on a daily basis based on the previous day's closing level, and such figures are rounded off to the nearest tick size. Given below is the sample of the circuit filter for Nifty for trading on 13th August, 2018, based on closing value of 10th August, 2018. (On 10th August, Nifty closed at 11,429.50)

In a nutshell, price bands for stocks and circuit filters for indices are designed as a risk protection mechanism for the markets in general and retail investors in particular.