Why do stocks hit the lower circuit and how do sell/buy stocks which have hit the lower circuit?

Why do stocks hit the lower circuit and how do sell

The stock market is known for volatility and players expect markets to be volatile. In fact, the concept of the stock market itself is largely driven by the idea of capitalizing on the short-term and long-term fluctuations in stock prices.

However, what if this volatility goes beyond the controllable range and results in erratic movements in stocks – and unprecedented profit/loss? SEBI has put in place mechanisms to keep price volatility in check, and that is by setting price circuits on stocks.

Circuits curb the movement of stock price beyond a maximum permissible limit and safeguard investors from any sudden out-of-the-box price movements which might catch them wrong-footed.

In a scenario where a stock is reacting wildly to a negative news development and has entered into panic selling where investors are dumping their investments, a lower circuit will come to the rescue. The lower circuit will limit any further fall in the stock on that given day beyond a certain percentage. If the lower circuit for a stock is fixed at 20%, no more selling will be allowed in that trading session beyond a 20% fall in the stock’s price.

What is a lower circuit?

A lower circuit is put in place to restrict a continuous spiral down of a stock’s price beyond a predefined percentage. The lower circuit defines the lowest tradable price for a stock in a particular trading session. The stock will be ‘frozen’ at the lower circuit till the time there are no fresh buyers who come to the rescue.

When a stock hits its lower circuit, there will only be sellers and no buyers, but because the stock is already trading at the lower circuit, no more sell orders are entertained. However, buy orders will be executed without any hindrance because the lower circuit is put in place to restrict further selling, not buying.

Let’s take up an example for detailed understanding.

On 24th January 2022, when there was an absolute bloodbath across Indian indices, a total of 875 stocks were struggling to find buyers and were frozen on the lower circuit. Among the stocks taking a beating was the market heavyweight ADANI GREEN. The stock was locked on its lower circuit of 5% and remained locked for the entire trading session.

Imagine the plight of the stock if the circuit was not in place, the panic selling would have eroded a larger portion of the stock’s value.

Why do stocks hit the lower circuit?

There may be varied reasons for stock to slump, 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/ AMC’s 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 by the time you’ll find out the root cause behind the fall, the damage would have been done.

Who sets the lower circuit and the circuit limit?

We just saw in the above example that the lower circuit for ADANI GREEN is set at 5%. But that’s not the case with all the stocks. The minimum permissible limit for the stock is decided by SEBI based on its previous day’s closing.

The lower circuit for different stocks may vary from 2-20% and is fixed by SEBI considering the volume, liquidity, and the category of the stocks. These circuit levels are not permanent and can be altered subject to periodical review. For liquid stocks, the circuit is hiked and for stocks, with dried up liquidity circuit is lowered.

You can find the minimum permissible price for each stock on the official website of NSE under the “Price Information” menu.

Alternatively, different brokers also provide this information.

Learn more about the regulatory bodies in the Indian stock market in our blog here

Can you sell a stock locked in the lower circuit?

No, because this would demean the very concept of applying circuit breakers, which is to arrest any further fall in the stock. At the lower circuit there are only sellers and no buyers, thus selling orders won’t be executed because there are no buyers for the stock at the underlying price.

During the day, the stock will remain frozen at the lower circuit unless fresh buyers come to the rescue.

In such situations, intraday buyers are in quandary because intraday trading requires you to square off your positions before the trading activity is halted for the day. However, due to the stock being locked in the lower circuit, they cannot sell their positions. Here, the intraday positions will automatically get converted into delivery, and the trader will be required to maintain sufficient balance in his trading account to take delivery of the positions by the next trading session. In case the trader fails to do so, the broker will sell the stocks for the shortfall amount in the next trading session.

The best you can do to exit a stock frozen at the lower circuit is to place a limit order, near the last traded price. In case the stock experiences fresh buying anytime during the remainder of the trading session, your order will get executed. However, there’s no guarantee for that, if there are no buyers till the closing time of the market, your order will be canceled.

Do not worry if this was a bit difficult to understand, we’ll take up an example to understand it.

On 10th February, 2022, RELIANCE INFRA opened at Rs 149.40 and got locked up in its lower circuit of 10%, to close at Rs 133.10.

Mr. A bought 100 shares of RELIANCE INFRA intraday when it was trading at Rs 145.

When the stock got locked in its lower circuit, Mr. A was unable to square-off his positions at the end of the day. Now, Mr. A must have a balance in his trading account by the next day to cover the full traded value, i.e, Rs 14500 (100 shares @ 145 per share). Otherwise, the broker will recover the shortfall amount by selling the shares and Mr. A will have to bear the loss.

How to save yourself from getting trapped in the lower circuit?

It’s clear that you cannot dump your buying positions when the stock is in the lower circuit band. Though you can take the help of one simple market practice that will help you exit your positions before the stock hits the lower level.

Stop losses can be used to exit positions before the lower circuit price is hit.

Place stop losses above the lower circuit price and the question of getting stuck at the lower circuit will never arise.

For instance, you have bought shares of company X at Rs 100. The lower circuit for the stock is at Rs 88. Here, to avoid getting trapped at the lower circuit, you can place a stop loss at any price above Rs 88.

Can we buy shares that are in the lower circuit?

Yes, buying is not halted at the lower circuit, in fact, those investors who have been eyeing quality stocks but have been unable to purchase due to high valuation may welcome the lower levels as buying opportunities. Plenty of sellers are available at the lower circuit and buying orders will be executed in a flash.

Here are some must-know tips for you while getting into equity investments.

Conclusion:

A lower circuit is a tool put in place by SEBI to arrest any unusual dip in stocks. The lower circuit ensures no further selling during the trading session as at the lower circuit there are no buyers and only sellers. Lower circuit levels are decided by SEBI and are subject to periodic review based on liquidity and volumes the stock is amassing. Though hitting the lower circuit is never a good sight, investors should understand one bad day doesn’t erode all the good the stock has done in the past. A lower circuit doesn’t mean something seriously wrong has happened with the fundamentals of the company. It should be seen as a single-day sell-off and in most cases, you’ll see buyers coming to the rescue in the following trading sessions.

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