March 9, 2020
What Is a Limit Down and Why Is This Being Used on US Stocks Today?
We started this week with a sea of red in the financial markets. Jitters about the escalating situation with COVID-19 were compounded by issues with oil, as it seems a price war may potentially be taking hold.
These concerns led to a panic in the markets and, as equities plunged, US stocks triggered a ‘limit down’. This has featured in all financial news reports today, but since it’s not something that happens so often in major markets you may be wondering what it means.
A limit down (or a limit up in opposite situations) is a circuit-breaker that is used in some markets to stop extreme levels of volatility. It has been used in US stocks since 2012, following a severe drop in 2010 when the Dow fell by over 1000 points in 10 minutes.
Essentially, the limit down stops the asset from falling any further in a single trading session once it has declined beyond a certain percentage. For example, this morning US stocks fell 5% in the futures market; this is considered ‘out of hours’ since the US trading session had not yet begun. As a result of this decline, the limit down was reached and trading was halted. In the opposite situation, where the price is rising dramatically, it would trigger a limit up and trading would also be stopped.
When this happens, all exchanges or brokers trading these markets must cease trading immediately until the trading session resumes.
The reason for these limits is pretty simple. The limits prevent an asset from reaching excessively high volatility levels and, in particular, the limit down is used to prevent panic selling which can lead to market crashes.
Obviously these cannot stop market crashes completely as the extreme market activity could continue once trading resumes, but they do help to limit it and bring a period of calm to markets to potentially give a chance for the panic to reduce. Whether or not that will be the case today is yet to be seen, but we will soon find out.