WHAT IS Price Continuity
Price continuity is a characteristic of a liquid market in which the bid-ask spread, or difference between offer prices from buyers and requested prices from sellers, is relatively small. Price continuity reflects a liquid market, for which there are many buyers and sellers for a given security.
Price continuity should not be confused with low volatility. However, there is a relationship between the two, as stocks with small average true ranges, a measure of volatility often applied to individual securities, may have more price continuity. The same is true of exchange-traded funds representing an index.
In general, however, most exchanges try not to restrict volatility, while promoting price continuity. This tends to promote efficient price discovery.
BREAKING DOWN Price Continuity
Price continuity allows markets to trade quickly and efficiently, by rapidly matching buyers with sellers. Without price continuity, the overall amount of trading volume tends to fall, and so can open interest of options and futures markets. In addition, a lack of price continuity sometimes halts market trading.
For example, say a fairly liquid security that trades more than 500,000 shares has a fairly narrow bid-ask spread. This spread widens, however, as does the average true range, widen when the company announces earnings that are either very strong or weak relative to expectations, as this new information is digested by market participants. However, price continuity continues if if a large number of traders step in to fill the void with more bids and asks.
On the contrary, systemic events break down price continuity. For example, say a government in Europe defaults on its sovereign debt, wiping out substantial value for particular banks and clamping down on the overall volume of global equity and bond trading. These types of events affect price continuity substantially. The gulf between bids and asks usually widen as a potential crisis unfolds.
Regulating Price Continuity
Some research suggests regulating price continuity to a degree promotes market efficiency. In most markets, exchanges set up trading rules for this very reason. For example, exchanges sometimes limit the daily absolute price change for a particular stock. Many markets also enact single-stock curbs and market-wide circuit breakers to keep bid-ask spreads fairly narrow.
For example, circuit breakers kick in when single-day declines for the S&P 500 Index are 7% or below its previous close. A Level 2 circuit breaker hits if the index drops 13%, and a Level 3 trips on a 20% decline, in which case the exchange closes the market for the trading day. All circuit breakers result in a 15-minute trading halt, unless they occur at or after 3:25 pm, in which case trading continues.
Curbs and circuit breakers not only reflect a lack of price continuity, they promote it by giving buyers and sellers more time to discover prices.