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July 1, 2012

In the Zone

U.S. Joins Rest of World with Limit Up/Limit Down

By Peter Chapman

The Germans have it. The British have it. The French have it. The Swiss, the Italians and the Japanese all have it. Now the Americans are going to get it.

Next February, the U.S. stock market will start smoothing out the fluctuations in its stocks under a "limit up, limit down" regime. Throughout the day, exchanges will calculate upper and lower price limits for individual securities, and prevent trades from occurring outside those bands.

The limit up/limit down procedure was proposed by the exchanges and the Financial Industry Regulatory Authority in April 2011, and approved by the Securities and Exchange Commission on May 31. 

The intent is to prevent spikes in prices-up or down-like those that rattled investors on May 6, 2010, during the "flash crash." Under limit up/limit down, moves in the 1,400 largest securities are capped at 5 percent.

The new system will replace the existing single-stock circuit breaker regime, in effect since the flash crash, which halts trading in stocks if a trade occurs outside of a given price range.

In general, the industry is supportive of limit up/limit down, calling it an improvement over the single-stock circuit breakers, but still harbors concerns over its operation.

"We're cautiously optimistic," Mike Corrao, chief compliance officer at Knight Capital Markets, told Traders Magazine. "It's a unique approach that tries to take into consideration the trading characteristics of a security. It forces the industry not to trade when a stock reaches the price where you don't want it to trade. Theoretically, it's a smarter test than the single-stock circuit breakers." 

Mike Carrao, Knight

Under the circuit breaker system, when a stock reaches a price deemed too high or too low, trading is allowed once, but then halted for five minutes. This methodology is considered flawed by many traders, as individual small trades have halted trading in some of the most active stocks, such as Citigroup, Intel and Cisco.

Still, halts are rare. A study done by Credit Suisse last year found that the circuit breakers were triggered only 111 times during the 18 months between June 2010 and September 2011. Over half the time, the halts were triggered by news-related trades, likely making them justified, said Credit Suisse. Erroneous trades, those caused by order entry mistakes, and thought to be a significant problem, triggered halts in only 17 percent of the cases.