What is Upper Circuit and Lower Circuit?

The stock markets are a collection of any and all venues where the shares of a publicly-traded company are issued, bought and sold. The parties involved in the stock market include the buyers and sellers of shares. When we think of “buyers and sellers”, most people think of the average Joe from the public that trades or invests in stocks. These people are called retail investors.

But these aren’t the only persons involved in the stock market. Apart from the individual retail investors, the stock market is also home to institutions such as, mutual funds, pension funds, investor groups, banks, etc.

What this means is that there are a lot of varied minds that operate in this environment. And where there are people and their minds involved, there is the aspect of psychology that needs due consideration as well.

Considering the fact that the stock market is made up of real, thinking humans at some level or another, we can understand why the prices move as erratically as they do. Sure, there is a pattern that can emerge that can be somewhat predictable, the exact market behaviour cannot be consistently predicted.

But due to emotional responses to the market, the erratic price movement can sometimes be very extreme. These extreme movements can cause the price to either climb way up or fall dangerously low. An extremely low price may seem good as it allows investors to purchase new stocks or a high price could be equated to profits.

In reality, the sudden rise or fall causes extreme volatility and results in capital erosion and other market imbalances.

To counter market instability due to overly emotional response to stock prices, circuit breakers called upper circuit and lower circuit were put in place. Today, we read about these circuit breakers.

Upper Circuit and Lower Circuit- An Overview

With the idea of investing becoming more and more popular and a larger segment of the market, I’m sure a lot of you have come across news articles regarding certain shares hitting their “upper circuits” or “lower circuit”. But what do these words mean?

Upper and lower circuits are price limits that apply to particular stocks or indices. Together, these are the two types of circuit breakers that are present in the stock market. That’s right, even stock markets have circuit breakers. Yes, the same ones that look like old fashioned switches and are often mistakenly called “fuse” in everyday conversations.

Well when I say same, I mean similar in function. There isn’t a real physical switch that someone flips that turns the stock market on or off.

Just like electrical circuit breakers stop the power supply when overloaded, stock market circuit breakers halt trading of shares and other instruments when “overloaded” as well. An “overload” for a stock market circuit breaker is caused by sudden and significant price movement.

A rise or fall in the price, if large enough, can and will trigger the circuit breaker.

Based on the percent of price movement, the duration of the halt is decided. For individual stocks, the upper or lower circuit percent is based on the direction of the price movement of the stock and its category. For index-based market-wide filter, the percentages are 10%, 15% and 20%.

If the circuit breaker for a singular share is triggered, trading in that particular share is halted. However, if an index falls or rises by any of the aforementioned percentages, the entire stock market is halted for the time period as specified below.

Let’s see how these percentages work with some examples.

Individual Share

Suppose share A is currently trading at ₹100 in the stock market with a circuit filter of 20%. In this case, if the price rises to ₹120 or falls to ₹80; the circuit breakers will be triggered and the corresponding halt period will be applied to that share.

Index/ Market Filter

These circuit breakers are triggered by the BSE Sensex or the NIFTY 50 index and are based on the points at which the index closed on the previous trading day. For example if the BSE Sensex Index closed on 15,000 points on the previous trading day.

Based on the percentages in the table above, a fall to or beyond 13,500 points, 12,750 points or 12,000 points or a rise to or beyond 16,500 points, 17,250 points or 18,000 points will trigger the circuit breaker. This will cause a market-wide halt in trading for the aforementioned periods.

Whenever the halt isn’t for the rest of the trading day, before trading resumes, there is a 15 minute pre-open call auction session where the equilibrium price for the stock is determined before trading resumes. This price is determined using demand and supply conditions in the market.

Another thing to note is that whenever trading is stopped for an instrument or even the market, derivatives relating to the concerned instrument or the entire derivatives market stop trading respectively.

How do stocks reach the Upper or Lower Circuit

The prices of stocks are controlled purely by the forces of demand and supply that the market freely exerts. If a stock has a demand that is greater than its supply, the price of the share rises and as the demand falls, so does the price.

Now you might be wondering, “If the demand or supply for the share determines its value, is the quality of the company’s operation relevant at all?” The answer to this question is, yes, it absolutely is relevant. Let me explain how.

As the company performs well, word of this positive operation spreads through people who are shareholders as well as other investors. Now, buying a share of the company gives investors ownership of the same.

So as the company does well, people want to gain the benefits of said improvement by being directly involved in the company. Existing shareholders want to increase their holdings and new shareholders want to get in on the action.

This means that the demand for the share increases. This means that people are willing to pay a greater price for said share, but only till a certain limit. And the price increases accordingly to accommodate this demand.

In the same way, as the company’s performance deteriorates, existing shareholders want to jump ship and abandon a falling company and new shareholders are not interested in acquiring any shares of the company.

This means that the demand for the share is falling and the price will reduce along with said demand as people will be willing to pay a lesser price that they think the company is worth.

As mentioned above, in both the cases of price rise and fall, the movement in share value happens to the extent that the market (read: investors) deems it to be worthy. Therefore, the price moves to a limited extent before settling at a point.

However, in case of the stock market, there is human involvement. The human element brings emotions to play. Sometimes the market over-reacts to the company’s performance and the share price rises or falls at an alarming rate. The significant change in value adds fuel to the fire and people either start to panic-sell (when prices fall) or manic-buy (when prices rise).

This bandwagon effect only pushes the prices in the same direction and brings volatility to the market. As these significant value changes take place, the prices eventually trigger the circuit breakers and trading in that stock or even the entire stock market is halted to calm this volatility.

It is important to have control over our emotions in those times and take practical decisions. But to take a pragmatic approach, you need to have complete knowledge about it. And knowledge is acquired over time, it’s not something that occurs to you overnight.

Quest by Finology has a marathon course on Beginners Guide to Stock Market, which means you will learn every little thing in detail. 

Conclusion

Whenever I think about the concept of circuit breakers in the share market and the trading halt that it brings into effect, I’m reminded of my time in school. I’m reminded of the time, when owing to the ruckus we’d create in class; after being compared to a fish market, we’d be made to follow the “5 minutes of pin-drop silence”.

Obviously, no one (in my class at least) made it the entire 5 minutes (the class clowns just had to act up🤷‍♂️). The trading halt seems like a more serious and well-enforced version of the “5 minutes of pin-drop silence”.

I hope this blog has been informative and has brought you some clarity regarding a recent buzz-word. If so, do share this blog and others with your social circles. And do let us know of other topics you’d like covered in these articles.

Until then, happy investing.