Discussion Topic: Circuit Filters
Today, we are going to discuss a very interesting term used in stock trading, i.e. - circuit filter. In this article, you will learn what is a circuit filter in stock trading? How do circuit filters work? Why are they needed? And what are the limits of circuit filters…
What is Circuit Filter in Stock Trading?
Circuit filter is a mechanism used by stock exchanges to restrict excessive volatility in stock market. It defines the maximum fluctuation in stock/index price allowed during trading. It also helps to control any intentional manipulation done in share prices by its operators.
If at any day, the maximum permissible price movement limit is hit (in either direction), then the trading of that stock or index gets suspended for a specific time period. Hence, it prevents a steep rise or fall in stock prices (also index prices).
This situation for stocks is also called as “the stock has entered into a circuit”.
What is a Circuit Breaker?
Factors such as market speculations, viral news, or intentional market manipulation force stock prices or indices to enter in a circuit. Many such conditions are beyond the control of stock regulatory authorities. Hence, they use the circuit breakers to handle such market situations.
In simple term, the circuit breaker is a set of rules defined by the stock regulatory authority to bring back stocks to their normal operational state in case an index or stock enters a circuit.
How Circuit Filters Work
When the stock price breaches a specified price band (up or down) as pre-decided by stock exchanges, trading in that particular stock is suspended for a definite time period.
For example, if a share price is running at $100 and there is a circuit breaker of 10%, it will suspend all trading activities on that particular stock if the share price goes above $110 or below $90.
Circuits Limit for Stock Exchanges (Stages of Circuits)
As a rule of thumb, there are three circuit filters (or more specifically circuit breakers) defined for indices - 10%, 15%, and 20%. These filters are applied to both Sensex or Nifty stocks/index whichever crosses the limit first (This is true for stock exchanges of other countries as well).
The effect of these triggers also depends on the time at which it occurs. Below are the details for the circuit filters:
Trigger 1: 10% Movement
- 10% movement in stock/index price on either will trigger this restriction.
- If the condition occurs before 1 pm - 1 hour halt in trading activities.
- If the circuit breached after 1 pm but before 2:30 pm - 30 minutes halt in trading activities.
- If the breach occurs after 2.30 pm - no halt
Trigger 2: 15% movement
- 15% movement in stock/index price on either will trigger this restriction.
- If the breach happens before 1 pm - trading activities on that script suspended for 2 hours.
- If the drift occurs is after 1 pm but before 2 pm - suspension for 1 hour.
- If the movement occurs after 2 pm – no actions are taken
Trigger 3: 20% Movement
- 20% movement in stock/index price on either will trigger this restriction.
- If 20% movement happens at anytime of a trading day, then the trading activity on that script will be suspended for the remainder of the day.
Though the above restrictions are widely practiced, there are some exceptions as well. For instance, the circuit filters are reduced for scripts that are not so liquid, No circuit filters are imposed on stocks that has derivative products, and circuit breakers can be widened for stocks that are normally liquid.
Why Circuit Filters Are Needed:
In the time of high volatility, circuit filters are much needed to prevent a stock crash.
Let us give an example. Let’s assume that a particular company releases its annual report which is showing huge revenue loss. So, it is highly likely that after reading the report everyone will start to sell the stock and the stock will begin to dip in a dramatic way. By imposing a circuit filter you are actually preventing the stock from an immediate crash.
Stock exchanges periodically review circuit filters for index and individual stocks. For instance, The National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) of India tend to review the performance of each stock and their circuit filters.
If any stock is observed to become more volatile or less volatile, they could relax or tighten the circuit filter limits for that particular stock.
We hope that you have enjoyed the above article describing the circuit filter in stock trading. Be with us to explore forex trading, stocks trading, and other money-making opportunities.
Leave us some comments if you have any questions or doubts about circuit filters and how they work, we will be happy to make your understanding clear.