A lower circuit is triggered when a stock sees a significant negative reaction, often caused by unfavourable news, resulting in a panicked sell-off by investors. This mechanism halts the stock from declining beyond a certain predetermined percentage on a particular day. For instance, if the lower circuit of a stock is established at 20%, no additional selling is permitted once the stock's price plunges by 20%.

Stock markets are infamous for their inherent volatility , frequently resulting in sizeable profits or losses for investors. Contemporary India is witnessing a pivotal transformation in its investment scene, driven by the burgeoning interest of the younger generation in stock trading. This trend has ushered in a distinctive shift in the Indian stock market. However, novice investors might find terminologies such as lower circuits or upper circuits overwhelming and confusing due to the scarcity and often deceptive nature of the available information.

Understanding the concept of circuits might not be as complicated as rocket science, but it's essential for investors to have a thorough understanding before making informed choices. By the end of this piece, you'll have a solid grasp of lower circuits, what they are, how lower circuits are implemented and most importantly, what to do when you hold lower circuit stocks, how to sell lower circuit stocks and what to consider if you are buying lower circuit stocks.

Regulating Stock Market Volatility

Circuit breakers & limits are pivotal in preserving stability and shielding investors. Two types of circuit limits exist: stock-level and market-wide. When a stock makes a dramatic move in any direction or reaches the maximum price level permitted for the day, it's said to have "touched the circuit." An upward swing activates the Upper Circuit , while a downward shift triggers the Lower Circuit.

Circuit limits objective is to control market imbalances instigated by price volatility. They operate as restrictions for specific stocks or indices, temporarily suspending trading in the stock market upon activation. This helps to mitigate extreme price swings triggered by panic buying or selling of a specific stock.

What is a lower circuit in the share market?

A lower circuit in the share market refers to a mechanism used by stock exchanges to prevent excessive selling in a particular stock. When a stock hits its lower circuit limit, it means that the price of the stock has fallen to its maximum allowed limit for the day.

Lower circuit stocks are those subject to circuit limits, which limit their price movement. Put simply, these stocks have hit the lowest permissible percentage by the stock exchange for price changes on a given trading day.

Lower circuits play a vital role in curbing excessive downward movement in stock prices. When a stock encounters considerable selling pressure with few buyers, it may hit the lower circuit. The specific level of the lower circuit is determined based on the prior day's closing price and may differ across stocks.

Generally, lower circuit stocks are associated with companies facing financial troubles or other serious issues prompting investors to divest their shares. Consequently, these stocks are more suitable for investors with a high-risk appetite as their prices can be highly volatile and subject to sudden slumps. However, they also bear the potential for significant returns. Once a stock hits the lower circuit, no more sell orders are allowed, and trading in that stock is temporarily halted for the rest of the trading session. However, buy orders can still be placed, as the purpose of the lower circuit is to limit selling activity, not buying.

Why do we have a lower circuit in the share market?

SEBI's implementation of lower circuits aims to protect investors from sudden and severe price declines that could result from panic selling or adverse market conditions. By establishing a predefined percentage threshold, the lower circuit prevents the stock from falling beyond that limit on a single trading day. This mechanism acts as a safety net, providing investors with a buffer against extreme downward movements in stock prices and avoiding potential losses.

Let’s look at an example. During the tumultuous market conditions on January 24, 2022, there was widespread decline in Indian indices, resulting in a significant impact on various stocks. ADANI GREEN, a prominent market heavyweight, was one of the stocks severely affected, with its price continuously hitting the lower circuit limit of 5%. As a result, trading in the stock was halted for the entire trading session. The presence of the circuit limit prevented further erosion of the stock's value, providing a safeguard against excessive panic selling and mitigating potential losses. Without the circuit in place, the stock could have experienced a more substantial decline in value, highlighting the importance of such measures in volatile market situations.

Investors should approach lower circuit stocks carefully, taking into account the associated risks and potential rewards. Grasping the dynamics of lower circuit stocks can help investors make well-informed decisions and navigate the complexities of the stock market.

Reasons for Stocks Hitting the Lower Circuit

There are numerous reasons why stocks may plummet, ranging from industry-wide selling to a ripple effect of index-wide offloading. The decline could be sparked by unfavorable news related to a specific stock, such as a halt in a company's impending acquisition or the exit of key senior management personnel. The decline could also result from substantial Asset Management Companies/ investors withdrawing their stakes, or Domestic Institutional Investors (DIIs) / Foreign Institutional Investors (FIIs) executing block trades. Moreover, the possibility of manipulative tactics by market operators should not be overlooked. The underlying cause could be varied, and by the time the reason for the fall is discerned, the damage is often irreversible.

At its core, the primary force that drives a company to hit a lower circuit is the interplay of supply and demand. However, several factors can influence these forces and potentially drive a stock or index to hit lower price thresholds. Reasons that may trigger lower circuits include:

1. Market sentiment

Negative market sentiment owing to a variety of factors can trigger lower circuits. These factors could include political disturbance, global economic conditions, geopolitical tensions, negative changes in interest rates such as repo rate, reverse repo rate etc. domestically or even internationally, changes in international or bilateral trade agreements

2. Company-specific news and announcements

Adverse news or proclamations related to the company, such as disappointing financial results or significant legal complications, incorrect synergy mix with a potential acquisition, poorly planned or executed mergers, bankruptcy or loan payment defaults, expanding to a new unknown market etc.

3. Liquidity issues

A shortage of liquidity in the market for a specific stock can trigger a lower circuit. This can happen when there aren't enough buyers or sellers to sustain a stable price for the stock.

Lower circuit limits in the Indian Markets

The lower circuit limit for a stock, is established by the exchange where it is listed. It is determined by taking into account an array of factors, such as the stock's volatility, trading volumes, market capitalization, and other relevant criteria. In the Indian stock markets , lower circuit limits are implemented by the 2 major exchanges, BSE (Bombay Stock Exchange) and NSE (National Stock Exchange), to keep a check on the volatility of individual stocks. Lower circuit limits are pre-defined percentage points, which if reached, halt trading for that particular stock for the day.

1. For specific stock categories as per the rules of the exchange, stock circuit limits (upper and lower) are usually set at 2%, 5% or 10%
2. No circuit limits for stocks that have derivative products or are part of the futures and options (F&O) segment.
3. All other stocks including including debentures, preference shares etc. have a stock circuit limit of 20%

When a stock hits its lower circuit limit, no further trades can take place that day at prices below the limit. This mechanism provides a cooling-off period for the market participants, preventing panic selling and giving them time to make informed decisions.

There are also index level or market wide circuit breakers. These market wide circuit breakers once breached for either BSE Sensex or the Nifty 50, whichever happens earlier will result in temporary suspension of trading in all equity and equity derivative markets in India. The market wide trigger limits are as follows -

This limit is typically expressed as a percentage of the index's closing price from the previous day. This pause allows the market to stabilize before resuming trading. In this period, neither can buyers place bids nor sellers offer their shares. Once the trading halt is lifted, trading activity can recommence and market participants can place their orders again.

Selling Stocks that Have Hit the Lower Circuit

We have understood what is lower circuit in share market, what are lower circuit stocks and lower circuit stocks in the Indian markets. Let’s figure out if you are holding stocks that have hit the lower circuit, then how you can sell lower circuit stocks.

You cannot sell stocks that have hit the lower circuit until the circuit limit has been removed. Navigating an exit from a lower circuit stock can be a daunting task as it implies the stock is hitting its lower trading limit. This results in a dearth of buyers in the market to purchase your stocks. It's recommended practice to exit lower circuit stocks, as extended exposure could result in substantial losses as the stocks price continues to fall.

1. Await Circuit Suspension

Usually, the lower circuit constraint is temporarily suspended after a certain duration, which can range from a day to a week or more, subject to the stock's volatility. When the circuit restriction is lifted, the stock can be freely traded, enabling you to potentially offload your shares at a more advantageous price.

2. Initiate a Sell Order at the Upper Circuit Limit

If you anticipate a rise in the stock's price, you could set a sell order at the upper circuit limit. Consequently, once the circuit limit is removed, your sell order is automatically executed, allowing you to sell your stocks at a potentially higher price.

3. Engage a Broker

A broker's assistance can also be sought to locate a buyer for your shares, even when the stock is trading at the lower circuit limit. It's important to remember, though, that this approach may entail additional expenses, like a brokerage fee or commission.

The most practical and simple method of offloading a lower circuit stock is to place a sell order during the pre-open session, specifically at 9 AM. The market operates on a first-come, first-served basis during the circuit break, and an early placed order might facilitate the timely sale of the stock. Thus, the pre-opening and After Market Order (AMO) can assist in exiting the trade even when the market has hit the lower circuit.

Considering the market's inherent volatility, trading in the lower circuit is not unusual. The market is subject to frequent ups and downs. In recent years, there have been numerous instances where the market has taken a significant hit due to limit breaches. As such, even after thorough research, if you find yourself stuck in the lower circuit, it's advisable to exit as promptly as possible by setting a sell order ahead of time.

Buying Stocks that Have Hit the Lower Circuit

Finding buyers is rare in lower circuit stocks, especially when there are significant market/ stock specific events. However, you can buy stocks that have hit the lower circuit. For those investors who've been monitoring high-quality stocks but couldn't invest due to steep valuations, these lower price levels might present excellent buying opportunities. As there are numerous sellers ready at the lower circuit, buy orders are usually executed swiftly. There are few strategies that can be considered when investing in stocks that have hit the lower circuit -

1. Fundamental Analysis

Do a thorough analysis & examination of the company's financial indicators, including its revenue, profit margins, level of debt, and cash flow. This review can indicate if the company possesses the potential for growth and profit generation in the future. Consider the management team's experience and track record in the industry. If the company's fundamentals are robust and its management team has consistently performed well, it could be a worthwhile long-term investment despite the current lower circuit price.

2. Technical Analysis

An alternative strategy involves studying the stock's price movements and chart patterns via technical analysis. This method involves reviewing price trends, trading volumes, and other technical indicators to spot patterns and predict future movements. Through this analysis, you can determine whether the stock is oversold or undervalued, and if it presents a good buying opportunity.

3. Take a Contrarian View

A contrarian investment strategy suggests investing in stocks that other investors are currently avoiding. This approach involves looking for companies experiencing temporary issues or negative press, which has led to a decrease in their stock price.

Investing in lower circuit stocks entails both high risk and high potential rewards. While these stocks can yield significant returns, it is crucial to conduct thorough research and fully comprehend the associated risks before making such investment decisions.

Factors to Consider Before Buying/ Selling Lower Circuit Stocks

When a stock hits its lower circuit limit, trading is halted for that day. This is often a sign of significant negative sentiment towards the stock or sector. Investing in stocks hitting their lower circuit limit can be a high-risk, high-reward venture. But it requires careful consideration and analysis of several key factors:

1. Reason for the Fall

Find out why the stock is hitting the lower circuit. This could be due to poor financials, corporate governance issues, negative news flow, or overall market pessimism. If it's a systemic issue, then investing at this stage could be risky.

2. Company Fundamentals

Investigating the company's financial health, competitive positioning, and growth prospects is vital. These indicators help assess the viability of the company's business model and its capacity to generate sustainable returns in the long run. If the company has heavy debt, negative earnings, and poor cash flows, then it might continue to hit lower circuits in the future.

3. Promoter Holding & Institutional Ownership

If promoters or institutional investors are continuously decreasing their stake in the company, it could be a red flag. It indicates their lack of confidence in the company's future prospects.

4. Industry/Sector Outlook

It is crucial to understand the broader industry dynamics. If the whole sector is doing poorly due to regulatory issues, disruptive technology, or cyclical downturns, then it might be better to avoid investing.

5. Market Conditions

The general market trends and specific factors affecting the sector or industry in which the company operates can greatly influence the performance of lower circuit shares. Thus, a thorough analysis of market conditions is necessary.

6. Trading Volumes

Trading volumes can provide an insight into market sentiment and investor interest. Low volumes might imply a lack of investor interest or liquidity issues, while high volumes could indicate strong investor demand.

7. Risk Management & Risk Tolerance

Investing in lower circuit stocks carries inherent risks. It's crucial to implement a solid risk management strategy, including using stop-loss orders, maintaining portfolio diversity, and limiting the proportion of capital allocated to lower circuit investments. Be mentally prepared - only invest if you're prepared to potentially lose your investment. These are high-risk stocks.

8. Stock Valuation

An essential factor is determining whether the stock is under- or overvalued based on various metrics such as earnings, cash flow, and others. Comparing these valuations with industry peers can provide a more realistic picture of the stock's potential for profitability. Look at the P/E ratio. A very high P/E ratio might indicate that the stock is overvalued. However, a very low P/E ratio might be a sign of distress. Other ratios like Price-to-Book value, Debt-to-Equity ratio, and Return on Equity can give you a better understanding of the stock's value and risks.

9. Management Quality

The competence and integrity of the company's management are vital. If the management is involved in any fraudulent activity or if they lack the capability to navigate through tough times, then the company might struggle to recover.

10. Liquidity & Diversification

Stocks hitting lower circuits often have low liquidity, making it difficult to exit positions. Be sure you're willing to hold the stock for the long term if necessary. As with all things related to investing - diversification is key! Don't put all your eggs in one basket. Ensure this forms a small portion of your portfolio to limit potential losses.

Investing in lower circuit stocks should be done with caution, and only after thorough research and consideration. It's also a good idea to consult with a financial advisor before making any investment decisions.

Conclusion

Market wide circuit breakers, lower circuit limits & upper circuit limits function as regulatory measures enacted by SEBI to shield investors and ensure a steady stock market. By placing restrictions on price movements, circuit filters curb excessive volatility and provide some protection against abrupt market shifts. Lower circuit limits play a crucial role in maintaining the order and stability of the stock market, especially in highly volatile situations. They act as a market safeguard, protecting investors from excessive losses due to abrupt and dramatic price drops. Lower circuits can be triggered by various factors, including negative news events, industry-wide selling, or significant withdrawals by large investors.

However, investing in stocks hitting their lower circuits can be risky. Hence, it requires in-depth understanding, thorough research, and careful analysis of the company's fundamentals and the reasons behind the sharp fall. Investors need to consider their risk tolerance, investment objectives, and the financial health of the company before investing in such stocks. Even then, such investments should only constitute a small part of a diversified portfolio to limit potential losses.

Check out this article on What is the ASM/ GSM List and How Does It Affect Stock Investors? and What is Upper Circuit in Share Market: Buying and Selling Guide.

FAQs

1. What is a lower circuit in stock trading?

A lower circuit in stock trading is a mechanism used by stock exchanges to prevent a stock's price from falling beyond a certain percentage limit in a single trading day. This limit, set based on the previous day's closing price, aims to curb panic selling and maintain market stability. When a stock hits its lower circuit limit, trading is halted for the rest of the day to prevent further price decline.

2. Why do stocks hit the lower circuit?

A stock hits the lower circuit limit when the selling pressure for the stock is so high that the price drops to the maximum allowed limit set by the stock exchange for that day.

3. What factors contribute to stocks hitting the lower circuit?

A stock hits the lower circuit limit due to excessive selling pressure, which can be triggered by factors such as poor financial results, negative news about the company or industry, changes in government policy or regulation, or a bearish market sentiment. Sector-specific downtrends can also cause individual stocks to hit their lower circuit limits. At times, unfounded rumors or speculation can create panic among investors, resulting in a stock reaching its lower circuit.

4. Should I sell a stock that has hit the lower circuit?

Deciding to sell a stock that has hit the lower circuit depends on factors such as the reason for the fall, the company's long-term prospects, its financial health, and your personal risk tolerance. If the stock's drop is due to systemic issues or poor financials, selling might be a consideration, if you can find a buyer. However, if you're a long-term investor and believe in the company's future prospects, holding onto the stock could make sense, particularly if the fall is due to a market overreaction or temporary issues.

5. What should I consider before buying a stock that has hit the lower circuit?

Before buying a stock that has hit the lower circuit, one should consider the underlying reasons for the steep fall, such as poor financial results, negative news, market sentiment, or regulatory changes. It is crucial to analyze the company's financial health, long-term outlook, the credibility of the management, and sectoral trends. Also, understanding your risk tolerance and investment goals is vital, as investing in such stocks can be risky and may require a long-term commitment given the potential liquidity issues.

6. How can I manage the risks associated with trading lower circuit stocks?

Managing risks associated with trading lower circuit stocks involves thorough research into the reasons for the stock's fall, the financial health of the company, and the overall industry trends. Diversification is crucial to spread risk across different assets, and such risky trades should only constitute a small part of your overall portfolio. Finally, understanding your risk tolerance and setting a strict stop-loss limit can help protect your investment from extreme losses.