What is Upper Circuit and Lower Circuit?

The stock markets are a collection of any 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 who 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 individual retail investors, the stock market includes 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 people and their minds are involved, psychology also needs due consideration.

Because the stock market is made up of actual, thinking humans at some level or another, we can understand why the prices move as erratically as they do. Sure, a pattern can emerge that can be predictable, but the exact market behavior 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 climb way up or fall dangerously low. A meager price may seem reasonable 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, capital erosion, and other market imbalances.
Circuit breakers called upper circuits, and lower circuits were put in place to counter market instability due to an overly emotional response to stock prices.

In this blog, you should be able to gauge the required information on the circuit filters, why they are applied, who applies them, and what you should do to avoid falling into the circuit trap.

What is the upper circuit?

The upper circuit is the maximum level beyond which a stock’s price or an index’s value can not rise in a day. Stocks many want to buy, but only some people are selling, might hit the upper circuit. Once a stock touches its upper circuit, it means only buyers are available, and no sellers are present. Upper circuits are calculated based on the previous day’s closing price.

Some stocks have upper circuits at 2% higher than their previous closing price. Other stocks might have their upper circuits at 5%, 10%, or 20% higher than their last day’s closing price.

Once a stock hits its upper circuit, it cannot move any higher on that day, but it can go lower if there is a fresh supply of shares in the stock market. However, stocks traded in the derivatives segment don’t have any circuit filter limits.

Stock indices like Nifty and Sensex also have circuit limits of 10%, 15%, and 20%. If the index hits the lower or upper circuit, trading will be halted for some time.

Why do stocks hit upper circuits?

A sudden demand for a stock could occur due to a news announcement such as a management change, new product development, or any other positive development. Buyers would then flock to buy the stock. However, you would see high volatility in the stock for a brief period, causing the stock price to rise rapidly. To prevent this from happening, the SEBI uses the upper circuit as a criterion to regulate price fluctuation.

Why are Upper Circuit limits instituted?

SEBI has initiated upper circuit limits for several reasons. For instance:

• They help regulate excessive price fluctuation on a single day
• They function as market curbs in case of a euphoric buying day
• They also help curtail stock price manipulation by traders in the market

When a stock hits its upper circuit?

Suppose a new automobile company suddenly overtakes the market share of the market leader, and the demand for this stock suddenly increases.

Stockholders of such a company are unlikely to sell their stocks. But people who want to buy might bid higher prices for these stocks. With upper circuits, it is possible to prevent a stock’s price from skyrocketing in a single day and protect investors from volatility and undue speculation like the pump-and-dump scheme on Telegram uncovered in January 2022.

Where can you find the Upper Circuit limit?

While SEBI oversees the circuit limits, they are declared by individual exchanges daily. Stock exchanges reveal stock filters on their website every day.

• In addition, if the volatility in stock continues, the exchange can transfer the stock to the T2T segment, where delivery becomes compulsory. This decision is also announced on the stock exchange’s website.

What is the Lower circuit?

The lowest level to which a stock’s price or an index’s value can fall is called the lower circuit. Many stocks want to sell, but only some might hit the lower circuit. Lower circuits are also calculated based on the previous day’s closing price, which may differ from stock to stock.

For some stocks, the lower circuit might be 2% lower than the previous closing price, while the lower circuit for other stocks might be 5%, 10%, 15%, or 20% lower than the last closing price. A stock’s price may not fall beyond its lower circuit in a single trading session, but its price may rise if people buy it.

Why do stocks hit Lower circuits?

There may be varied reasons for stock to slump, and it could be a domino effect of index-wide selling or industry-wide selling. It could be because of a negative news development about a particular stock, like the exit of senior key management personnel or disruption of a potential deal for the company.

It could be because of big investors/AMCs pulling out their investments or FIIs and DIIs making some block deals. You cannot even rule out the possibility of an operator game. So the reason could be anything, and the damage would have been done by the time you find out the root cause behind the fall.

When a stock hits its lower circuit?

Suppose news breaks that a particular company was involved in illegal business practices. The government is expected to crack down on this company. Now, the stocks of this company become unwanted. The existing stockholders will not be able to sell their shares as no one would want to buy.

When no one buys a stock, its price might drop. The fear of investing in a stock that is already falling may lead to the stock price to keep falling. To prevent this, lower circuits are set.

Upper and lower circuits for indices

Need and implication of circuit breakers

The prices of the stocks are sensitive to any positive or negative news related to a particular industry, company, or any political change, among many other factors. Such information drives the market sentiment and influences the price volatility of the stocks. An extreme price fluctuation can result in panic among investors and often lead to rash decisions as they are almost always the last party to react to a particular event or news.

To avoid such scenarios, circuit breakers were introduced to protect investors’ interests and safeguard them from any price manipulation by stock operators. A circuit breaker allows investors to react to market fluctuations calculatedly rather than make a hurried or panic-driven decision.

Pros and cons of circuit breaker 

The introduction of circuit breakers gave investors a pause to react to market fluctuations better and protect their interests. However, there are several pros and cons of a circuit breaker. Some of such pros and cons are mentioned below.

a. Pros

Some of the pros of the circuit breakers are mentioned below.

1. The biggest advantage of circuit breakers is the halt in trading activities for a fixed duration. This allows the investors to get all the relevant facts regarding the triggering event and make their investment decisions accordingly.
2. It protects investors from speculative trading, potentially leading to huge losses.

b. Cons

Some of the disadvantages of circuit breakers are mentioned below.

1. It restricts real-time price movement during the market halt.
2. Investors with early access to the market news and sentiments can take better advantage of the same compared to investors who may need to be aware of such a circuit break.  

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