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

 

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 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. Read more about lower circuit stocks