What is Limit Down
The limit down price is the maximum amount by which the price of a commodity futures contract may decline in one trading day. Limit down also refers to the maximum decline permitted in individual stocks on certain exchanges before trading curbs kick in. The limit is generally set as a percentage of the market price of the futures or stock or occasionally as a dollar amount. These limits were introduced to counter unusual market volatility and prevent panic-driven selling that usually compounds the initial price decline.
BREAKING DOWN Limit Down
Some futures markets close trading of contracts when the limit down price is reached; others allow trading to resume if the price moves up from the day's limit by a pre-determined amount. If there is a major event affecting the market's sentiment toward a particular commodity, it may take several trading days before the contract price fully reflects this change. On each trading day, the trading limit may be reached before the market's equilibrium contract price is met. This can be a scary experience for traders who are unable to exit their trading position because trading on the exchange is halted as soon as the limit down price is met. This can mean a trader has to suffer several days of losses before enough liquidity is restored to fully exit the position.
In June 2012, the Securities and Exchange Commission approved two proposals put forward by the national securities exchanges and FINRA to counter unprecedented volatility in individual stocks and the U.S. stock market following the 2010 flash crash. One proposal aims to establish a "limit up-limit down" mechanism that will "prevent trades in individual stocks from occurring outside of a specified price band, which will be set at a certain percentage above and below the average price of the security over the immediately preceding five-minute period." For example, the percentage level for liquid stocks, such as those in the S&P 500, will be 5%, and 10% for other listed securities.
Limit Down Halting Volatility
These proposals were put in place following the 2010 flash crash in the U.S. stock market. A flash crash is an event in electronic securities markets wherein the withdrawal of stock orders rapidly amplifies price declines. The result appears to be a rapid sell-off of securities that can happen over a few minutes, resulting in dramatic price declines. Putting in place more robust limit down trading regulations is intended to counter the effect of ever-faster computer-generated trading that can lead to a flash crash.