Sunday, January 6, 2008

Do price limits behave like magnets?

I was reading a paper that was published by my friend Purnendu Nath (PhD Finance - London Business School). The paper is titled “Do price limits behave like magnets?”

Many major stock and commodities exchanges have instituted procedures to limit mass selling in times of serious market declines or irrational bull runs in a single day. These mechanisms include Circuit Breakers, the Collar Rule, and Price Limits. Circuit Breakers establish whether trading will be halted temporarily or stopped entirely. The Collar Rule and Price Limits affect the way trading takes place. In price limits, the exchange places restrictions on upper and lower limits (e.g. plus or minus 10% of the previous day’s closing price). Trading does not stop when the price limit is reached, however trades must take place within the specific range. The main reason for price limits is to ensure prices do not drop or increase dramatically in a single day.

For his paper, Purnendu collected tick data from the National Stock Exchange of India (NSE) – over 110 million trades in a 14 month period. He proves using empirical analysis that price limit does not suck in prices in its neighborhood. In other words, the price varies across the band and is not necessarily attracted to the upper/lower limit.

He also shows that price limits do not always cause acceleration in trading. Using regression and statistical analysis, he shows that for upper price limits there seems to be a reduction in trading activity as a stock approaches its limit price. For lower price limits, there is acceleration as a stock approaches the limit. However, it cannot be concluded that the existence of a lower price limit causes the acceleration in trading. That falling prices evoke fear and induce panic related trading is a possibility that is also confirmed by examining the extent of trading at the limit prices.

Price limits do have benefits. They do prevent stock market overreaction and do not necessarily cause it.

In the United States, the SEC has institutionalized price limits in the “futures” market.

Nice work, Purnendu!!!!

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