Limit Down: When Stocks Need a Circuit Breaker

What is Limit Down?

Limit downs are the maximum allowable drop in an asset or market for one day. At the time of writing this, 9 pm AEST March 16th 2020, the Dow Jones futures market is currently locked limit down 5% after news that the Federal Reserve will lower interest rates to 0% and provide $700b in quantitative easing to help fight the effects of the coronavirus. This means that pricing is stuck down 5% until somebody offers a bid above the 5% decline if no bid is provided above the 5% decline the price will remain locked until the US stock market opens in around 3 hours.

Stocks can also a trigger limit up if they rise too quickly; however, a market can only trigger a limit down. Depending on the market, a limit down may trigger a break in trading or the close of the market.

What is a Circuit Breaker?

It’s important to point out that not all markets have a limit down and limit downs are highly controversial with many people believing in a free market that should be allowed to rise and fall purely based on the supply and demand of its users. As mentioned above the Dow Jones futures market will lock on a 5% decline but the Dow Jones index will not. In a scenario where the Dow Jones Index fell by 7% during trading a ‘circuit breaker’ would be triggered and the market would take a 15min recess. All pricing would be frozen for this period and if after reopening the Dow continued to decline until it hit a 13% intraday drop the market would again take a 15min recess. The final circuit breaker is reached if after the second recess markets continue to decline until they reach an intraday decline of 20%. At this point, the market is closed for the day to avoid further losses.

Why Do We Have Limit Downs?

On May 6th 2010 the Dow Jones index plunged 9% within minutes only to recover just as quickly. While an official cause has never been named it is widely accepted that high-frequency trading was primarily to blame for the events that unfolded. Years later, it would become a significant factor in the introduction of limit downs. The new rules aimed to reduce manipulation and error within the markets.

Kyle Schache
Kyle Schache
Like many, I wasn't as good with money as I should have been in my late teens and early twenties. Now in my late twenties and the holder a bachelor and masters degree both specialising in finance I spend my time optimising my investments and providing general advice to others.
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