Published , by Captain Business
Published , by Captain Business
Investing and trading in stocks is all the rage these days. With countless new people entering the space once dominated by Wall Street, there are some rules governing the market that people might not know about. In recent weeks, we have witnessed unprecedented volatility in stocks like AMC and GameStop, which has led to trading halts. In this article, we will explain how stock trading halts and market circuit breakers work.
Last week, many traders took to Twitter and Reddit to complain that the Robinhood investing app had blocked trading on AMC during its massive short squeeze. This is a fair concern, as this is what happened earlier this year when the first Reddit-fueled short squeeze attack brought GameStop to nearly $500/share before trading was limited. What happened last week, and is likely to happen again in these meme stocks, was not a limitation of trading by any one company. The stock market has rules to limit volatile moves in either direction.
A stock can be halted for a number of reasons. A stock trading halt is a temporary pause of activity for a particular stock or security at one or more exchanges. Different reasons for halts include news events (like earnings releases), a technical issue, regulatory concerns, or even to correct an order imbalance. Halts are also triggered by severely volatile movements, leading to circuit breakers.
Stock market exchanges can also halt trading to stop panic selling thanks to new regulations put in place following the "Flash Crash" of 2010. Market-wide circuit breakers come into effect when the benchmark S&P 500 Index drops 7% or more in a single day. Level 1 circuit breakers come into effect with 7% declines, with Level 2 hitting when declines top 13%, and Level 3 is triggered on days when the market drops 20%. Level 1 and 2 circuit breakers will halt trading for 15 minutes, but will not halt trading after 3:25 p.m. ET. After a Level 3 breach, exchanges will remain halted for the rest of the trading day.
There are also rules in place for individual stock circuit breakers. The exchanges and the SEC got together and came up with the Limit Up/Limit Down Plan. Please take a look:
Plan
On May 31, 2012, the Securities and Exchange Commission (SEC) approved, on a pilot basis, a National Market System Plan, known as the Limit Up/Limit Down (“LULD”) Plan, to address extraordinary market volatility. The Plan was approved as a permanent rule on April 11, 2019. The LULD Plan is administered by the LULD Operating Committee, comprising a representative from each of the Participants. The current Participants are the Cboe BZX Exchange, Inc., Cboe BYX Exchange, Inc., Cboe EDGX Exchange, Inc., Cboe EDGA Exchange, Inc., Financial Industry Regulatory Authority, Inc., Investors Exchange LLC, Long-Term Stock Exchange, NASDAQ BX, Inc., NASDAQ PHLX LLC, The Nasdaq Stock Market LLC, New York Stock Exchange LLC, NYSE American LLC, NYSE Arca, Inc., NYSE Chicago, Inc., and NYSE National, Inc. The Plan and any amendments to it are filed with and approved by the Securities and Exchange Commission in accordance with Section 11A of the Securities Exchange Act of 1934.
Overview
The Plan is designed to prevent trades in NMS Stocks from occurring outside specified price bands, which are set at a percentage level above and below the average reference price of a security over the preceding five-minute period. The percentage level is determined by a security’s designation as a Tier 1 or Tier 2 security. Tier 1 comprises all securities in the S&P 500, the Russell 1000 and select Exchange Traded Products (ETPs). Tier 2 comprises all other NMS securities, except for rights and warrants, which are specifically excluded from coverage. The Plan applies during regular trading hours of 9:30 am ET - 4:00 pm ET.
Calculation of Price Bands
The price bands, consisting of a Lower and Upper Price Band for each NMS Stock, are calculated by the two SIPs – CTA and Nasdaq UTP. The SIPs calculate upper and lower price bands by applying a formula to a Reference Price, which is the arithmetic mean price of Eligible Reported Transactions over the prior five minute period. (The first Reference Price of the day is either the primary market’s opening price or the primary market’s previous day’s closing price/last sale when opening on a quote. If no eligible trades have occurred in the prior five minutes, the previous Reference Price remains in effect. The Reference Price is updated after 30 seconds only if a new Reference price would be least 1% away from the current Reference Price.
The Price Bands are calculated by multiplying the current Reference Price by the applicable Percentage Parameter and then adding or subtracting that value from the Reference Price and rounded to the nearest penny.
Price Band = (Reference Price)+/- ((Reference Price)x (Percentage Parameter))
Operation of Price Bands
When the National Best Bid (Offer) is below (above) the Lower (Upper) Price Band, the SIPs disseminate the National Best Bid (Offer) with an indicator identifying it as unexecutable. Trading immediately enters a Limit State if the National Best Offer (Bid) equals but does not cross the Lower (Upper) Price Band. When a Limit State occurs, the SIPs indicate the National Best Bid (Offer) as a Limit State Quotation. Trading exits a Limit State if, within 15 seconds of entering the Limit State, all Limit State Quotations are executed or canceled in their entirety. If the market does not exit a Limit State within 15 seconds, the primary listing exchange declares a five-minute Trading Pause. The Trading Pause may be extended for another five minutes. Thereafter, all markets may resume trading. If a security is in a Trading Pause during the last 10 minutes of regular trading hours, the primary listing exchange will not reopen trading and will attempt to execute a closing transaction using its established closing procedures.
A Straddle State occurs when the National Best Bid (Offer) is below (above) the Lower (Upper) Price Band and the NMS Stock is not in a Limit State. For example, assume the Lower Price Band for an NMS Stock is $9.50 and the Upper Price Band is $10.50, such NMS stock would be in a Straddle State if the National Best Bid were below $9.50, and therefore non-executable, and the National Best Offer were above $9.50 (including a National Best Offer that could be above $10.50). If an NMS Stock is in a Straddle State and trading in that stock deviates from normal trading characteristics, the primary listing exchange may declare a Trading Pause for that NMS Stock.
A lot of traders are quick to blame Robinhood and other trading platforms when halts occur, and it is fair to be skeptical, but in most cases halts were ordered by the stock exchange. What happened in January 2021 with GameStop, AMC, and other meme stocks was the result of a shortage of shares. Many r/WallStreetBets traders feel like their trip to the moon was cut short by Robinhood and their market maker Citadel Securities, and it is totally right to feel that way. They refused to allow trading. What makes trading halts different is that they are built into the stock exchanges to prevent volatile panic selling.
In the absence of the Uptick Rule, which prevented the relentless short selling of modern-day algorithmically-driven dark pools and hedge funds, meme stock longs are still in a very precarious spot. It is important to know what is happening, and I hope that this guide will help you get through any volatile move in a stock or the overall market. While it is entirely possible that your broker or trading app has limited trading on your favorite stock, it is also possible that the rules of the stock market have enforced a temporary volatility cooldown.
This article is only meant for educational purposes, and should not be taken as investment advice. Please consider your own investment time horizon, risk tolerance, and consult with a financial advisor before acting on this information.