Limit Up, Limit Down: CNBC Explains
A couple of devices that major exchanges use to stop manipulation or extreme volatility in the markets are called "limit up, limit down." CNBC explains what these are and how they work.
What is Limit Up?
This is the maximum amount by which the price of a commodity futures contract may advance in one trading day.
Simply put, it's the top price a contract can be traded before an exchange would stop its trading.
The exchange sets this highest limit at what it thinks would be a price that would cause manipulation or volatility. The price varies from commodity to commodity.
Some markets will allow the contracts to resume trading if the price moves away from the day's limit.
What is Limit Down?
Just the opposite of limit up, this is the maximum amount by which the price of a commodity futures contract may decline in one trading day. So it's the lowest amount a commodity can be traded before an exchange halts trading.
Like limit up, the exchange sets the lowest limit at what it thinks would be a low price that would cause manipulation or volatility. The lowest price varies from commodity to commodity.
And also like limit up, if the contract prices do go higher away from their limit down, exchanges will allow trading to resume.
How do limit up, limit down work?
Say that corn futures have a price limit of 30 cents for the day. Suppose corn closed at $3.30 the previous day. The corn futures can only trade as high as $3.60 or as low as $3 during the day's trading session. No orders can be filled outside of those limits.
When were limits first used?
Limits were created in 1988 and percentage move limits have been used since 1998.
Limits are calculated after each quarterly expiration of a futures contract based on the average closing price for the contract.
What are commodities?
Usual examples of commodities are grains, gold, beef, oil and natural gas—but the definition has expanded to include financial products such as foreign currencies and indexes. The sale and purchase of commodities is usually carried out through futures contracts on exchanges.
Commodity futures contractshave a final date by which the contract must be delivered in order for the terms of the contract to be fulfilled.
What is the difference between limit up, limit down and circuit breakers?
As we've said, limit up, limit down would let commodity futures contracts trade within set boundaries, but stop if prices stray beyond them.
Circuit breakers, on the other hand, are a market safety feature and temporarily stop trading when there is a computer-induced plummet in prices. This occurs when the market has fallen by a certain percentage point set by the exchange.
The major difference between the devices is that circuit breakers would be used to stop trading across the whole exchange—while limit up, limit down are confined to futures contracts and happen quite often during a trading day.