What Is a Daily Trading Limit?
A daily trading limit is the maximum price range limit that an exchange-traded security is allowed to fluctuate in one trading session. Limit up is the maximum amount a price is permitted to increase during one trading day. Limit down is the maximum permitted price decline occurring over one trading day. Trading limits are examples of circuit breakers—interventions employed by exchanges to help maintain orderly trading conditions during turbulent markets.
Daily trading limits are often used in the derivatives market, especially for option or futures contracts, to limit excessive volatility. Exchanges impose these limits to protect investors from extreme price movements and discourage potential manipulation within the markets.
- A daily trading limit is the maximum amount, up or down, that an exchange-traded security's price is allowed to move over the course of a single trading session.
- Daily trading limits are imposed by securities exchanges to protect investors from extreme price movements and discourage potential manipulation within the markets.
- Daily price limits are used in the forex markets as well, whereby a country's central bank imposes limits to reduce the volatility of its currency.
Understanding Daily Trading Limits
Daily trading limits are price ranges established to curtail excessive volatility that can be detrimental to the orderly functioning of markets, especially in highly volatile derivatives markets. Their purpose is to lower extreme market volatility or manipulation in relatively illiquid markets, especially since derivative markets are characterized by their high levels of leverage.
- Once a price limit has been reached, trading can still continue at that limit but the price will not cross the price set for the daily trading limit.
- A market that reaches its daily trading limit is referred to as a locked market.
- Other descriptive monikers include limit up or limit down, depending on whether the upper or lower end of the range has been reached.
- At times, daily trading limits may be removed during the expiration month of a derivatives contract (typically futures), because prices can become especially volatile.
- Daily price limits are used in the foreign exchange markets as well, whereby a country's central bank imposes limits to reduce the volatility of its currency.
Here’s a hypothetical example: suppose the daily trading limit for a particular commodity is 50 cents per bushel and the previous day’s settlement was $5.00. In this case, traders cannot sell for less than $4.50 or buy for more than $5.50 per bushel during the current session.
If either of the daily trading limits were to be reached, then this commodity would be deemed to be a locked market. It would also be described as having gone limit up or limit down based on whether the upside or downside limit was reached.
How Daily Trading Limits Impact Traders
Daily trading limits can significantly affect trading given that prices can potentially move higher or lower much more quickly once the respective extreme has been reached.
For example, U.S. wheat futures locked up 30-cent daily trading limits in early 2008 for several consecutive sessions amid heavy buying from both speculators and grain users. The underlying cause of the volatility was driven by an uncommon amount of crop losses that reduced supply. In response, the Commodity Futures Trading Commission raised the daily trading limits and exchanges increased margin requirements to suppress speculator demand.
Currency markets are a popular example of daily trading limits imposed by central banks to control any instability. For example, in the past, the People's Bank of China has imposed a daily trading limit on the renminbi, allowing it to move within a band as narrow as 0.3% and as a wide as 2%. Central banks defend these trading limits by changing the composition of their foreign exchange reserves.
Daily trading limits can also influence asset valuations. For example, fundamental factors may have an effect on the true value of a futures contract or currency, but an inability to proficiently reach that price could cause an asset to be valued inappropriately.
Example of a Daily Trading Limit
For example, assume that a lumber futures contract is selling for $3.50, and has a previous day's close of $4. The exchange sets the initial daily trading limit as $3.75 - $4.25.
It has been a particularly dry growing season, and headlines this morning report that a massive wildfire has broken out and threatens a prime forest growing area. This event would cause the futures price to rise and perhaps try to pass the $4.25 limit up. The following day the exchange may expand the daily limit to $4.60.