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August 1, 2011

Thumbs Up for Limit Up/Limit Down

By Peter Chapman

Also in this article

The trading community likes the proposed limit up/limit down rule, but still has quibbles. In April, the securities exchanges and the Financial Industry Regulatory Authority proposed a reworking of the trading halt mechanism put in place after last year's "flash crash." As Traders Magazine was going to press, comment letters began streaming into the Securities and Exchange Commission, which must approve the proposal.

The response from traders is largely positive. "The trading community did not like the individual circuit breakers," said Steve Nelson, founder of the Nelson Law Firm and an attorney for the New York chapter of the Security Traders Association. "Limit up/limit down is seen as an improvement over that system."

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Under the current circuit-breaker regime, trading in a stock is halted for five minutes if the price rises or falls by 10 percent or more during any five-minute period. The goal is to reduce volatility by allowing the market to "catch its breath" and find the natural level of the stock's price.

Traders aren't crazy about the mechanism, however, because halts can be triggered by so-called "erroneous" trades, those done at prices far removed from the national best bid or offer. In the year or so since the individual stock circuit breakers were implemented, several stocks have been halted needlessly, including some very active names, such as Citicorp.

Formally known as the "Plan to Address Extraordinary Market Volatility," the limit up/limit down proposal seeks to improve upon the original. First, it is designed to prevent erroneous trades from occurring. Second, it seeks to avoid a trading halt by introducing a 15-second "limit state" of continuous trading before any halt can occur. The limit up/limit down proposal is modeled after a similar scheme used in the futures market, but is more complex.

The SEC published the proposal in the Federal Register on May 25. After a 21-day comment period, it intended to determine whether or not to approve the rule, the commission wrote in a press release. As of mid-July, the SEC had not made a decision. The major points of the proposal and criticisms follow.

Price Bands

A price band is calculated and disseminated by the Securities Industry Processors (exchanges) on a continual basis throughout the day. It is based on a reference price, calculated as the average of the last sale during the preceding five minutes. For the largest stocks, the upper limit of the band is 5 percent over the reference price. The lower limit is 5 percent below the reference price. For smaller stocks trading at over $1.00, the limits are 10 percent away from the reference price. Orders that fall outside these bands are rejected by the exchanges. That eliminates the possibility of erroneous trades.

Limit State