Stock price of a company is governed by several factors such as financial results, management policies, and external factors such as sector specific news or government policies. The wide perception of investors and traders leads to movement in stock implying that all information is discounted and reflected in the share price.

Share price is a reflection of the emotion of its participants.  For every buyer, there is a seller. For every bull, there's a bear.

However, sometimes share prices can move very swiftly in any direction. Such movement can be because of panic in market, news or simply manipulation of prices. A circuit breaker is a system which ensures that any such swift movement in any direction is based on logic rather than anxiety/panic.

What is a Circuit Breaker

The increase in volatility in the market may put retail investors at a disadvantage. This is because retail investors are almost always the last to react to news and sell or buy a stock. To avoid such volatility, the Securities and Exchange of India has instituted circuit filters and price ranges in the market.

Exchanges have Index-Based Circuit breaker which is applied at three-stages of index movement in any direction. These three stages are 10%, 15%, and 20%. The trigger will bring a coordinated halt in all equity and equity derivatives market. The market-wide circuit breakers are triggered by movement of either the S&P BSE Sensex or the NSE CNX Nifty, whichever is breached earlier.

The percentage calculation is as per previous close of the index. There is also another condition attached to it which is time at which these circuit breakers are triggered. The details are mentioned below.

Circuit filters/Price Bands

Sebi has prescribed that all individual shares will have appropriate price bands up to 20% either way except for the shares having derivatives products on them. These price bands are applicable to all stocks ranging from 2% to 20% either way from the previous close. Such price bands are introduced to keep a tab on price manipulation and fraudulent activities.

Price bands determine the range in which a security can move. To illustrate, a 10% price band implies that the security can move plus or minus 10% of its previous day close price on a given day. The downward revision is a daily process whereas upward revision, subject to the satisfaction of criteria, is a bi-monthly process conducted by the stock exchange.

No price band is applicable to securities on which derivative products are available.

Stocks that are traded in Futures and Options segment have no circuit filters for the single reason that they have derivatives available on them. The purpose of introducing derivatives on any share is to provide hedging opportunities in the market.

So even if a share has moved beyond 10/20% in any direction, a trader/investor has the option to hedge his/her position by trading in options/future contracts.  Any trader entering into the derivatives market should understand the risk and is looking for volatility and leveraged positions. Lastly, derivatives market is for traders and retail investors should reasonably use it for hedging risk.

Mustafa Nadeem is CEO at Epic Research