Market Operations - Price Limits
Price limits, the levels that securities values are allowed to rise or fall in a day, have direct effects on price changes and margins. Specifically, the daily price limit is the maximum price advance or decline from the previous day's settlement price, permitted during one trading session, as fixed by the rules of an option or future exchange. Once controversial, price limits have become part of the landscape. Theorists still debate whether such regulations have the desired effect of curbing mob psychology and allowing the markets to cool off, rather than move prices beyond fundamentally rational bounds.
Effects on Price Change
The limits are stated in terms of the previous day's closing price plus or minus a fixed quantity of dollars or cents per unit. Once a futures price has increased (decreased) by its daily limit, there can be no trading at any higher (lower) price until the next trading day. CBOT's daily limit for a corn, for example, was currently $0.20/bushel and the previous day's settlement price was $2.36 (236'0 by CBOT's conventions), trading will be suspended for the remainder of the day at any price greater than $2.56 or less than $2.16. The following day, it can again move by $0.20/bushel.
In some futures contracts, the limit may be expanded or removed during a trading session for a specified period of time. This could occur after the contract is at "locked limit," the price that has advanced or declined the permissible limit during one trading session, according to exchange rules.
These exceptions exist because prices can become increasingly volatile during the month preceding the expiration date. This is a natural result of professional hedgers and speculators unwinding their positions, and the market has no interest in straight-jacketing that basic dynamic. Price limits are intended solely to prevent panicked buying and selling.
Effect On Margin
"Circuit breakers," a system of coordinated trading halts and price limits designed to provide a cooling-off period during large, intraday market declines, were first introduced after the crash of 1987.
Daily price limits are one type of circuit breaker. Many believe they have a steadying effect on margins because they ensure that the end-of-day settlement price will be more or less within the maintenance margin. This means that margin calls are all the more rare in the futures market.
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