Lock Limit

What Is a Lock Limit?

A lock limit is a predetermined price shift set by an exchange, which, if violated, results in the suspension of trading in that instrument above the lock limit price. With the related terms "curbs" or "circuit breakers" used in the stock markets, "lock limits" usually refer to the futures markets.

Lock boundaries aid in market regulation and help to maintain their tranquility and order. Trading is suspended outside the lock limit price, though traders may still be able to deal at that price or within it.

Lock limit halts may be permanent, such as for the entire day or momentary. These requirements are unique to each futures contract.

A locking limit could sometimes last as little as 5mins.

They are not commonly used in practice, and various exchanges may have different regulations and implementation procedures. However, one recent example of this happening was May 31, 2012.

The US Securities and Exchange Commission (SEC) approved the National Market System Plan to address extraordinary market volatility.

This plan was created to prevent NMS stock trades from occurring above or below-specified values. These prices are established at a level above and below the security's average reference price over the previous 5-minute period.

That level is determined by a security's designation, whether Tier-1 or Tier-2. Tier-1 includes all securities in the S&P 500, the Russell 1,000, and certain Exchange Traded Products (ETPs). Tier-2 consists of all other NMS securities except for rights and warrants

Understanding a Lock Limit

Exchanges use lock limits to control the volatility of trading assets. They are used in both the stock market and the futures market, though the stock market uses the word "circuit breaker" more frequently. Nevertheless, the idea remains the same.

At all times, lock restrictions are in effect and are applied to upward and downward movements. For instance, if the limit on wheat is $0.28, a lock will be triggered by a move of $0.28 up or down from the previous closure.

Trading will not take place below the restricted limit if the price has fallen. It's referred to as “stop down.” The futures contract is "limit up" if the price hits the upper limit. Trading is prohibited during the lock period above this amount when happens.

Trading may be completely suspended or restricted to the area inside the lock limit price during a lock limit, depending on the specific futures contract.

For example, if the price is "limit down," a large buyer could enter the market, buy things from the sellers at the lock limit price, and then bid the price up to push it above the lock limit.

Trading would then continue as usual so long as the price remained above the lock maximum. When the limit is reached, the futures contract may, in some instances, be suspended for the day.

The financial sector also uses other kinds of locks:

• A loan lock occurs when a lender agrees to hold a customer's interest rate at a particular rate for a predetermined amount of time.
• A mortgage rate lock float down, which retains a specific rate for a loan, is an option to lower the interest rate if overall market rates decline.
• A treasury lock is an arrangement to lock in a particular rate, typically carried out as a futures contract for a set amount of time.
• An agreement called a "lock-up" forbids insiders of a business from selling their shares for a predetermined amount of time. They are frequently applied during an initial public offering (IPO). Lock-up times are usually 180 days long, but they occasionally range from 90 days to one year.
• The term "locking in profits" describes realizing previously unrealized gains in an asset by selling all or some of the holdings.

How Lock Limits Work

Lock Limits are frequently related to the futures market. They happen when the contract price of a commodity instrument shifts outside of its permitted range. Trading ends for the day beyond that price when this happens. Limits can either be “up limits” or “down limits.”

Consider the last closing price for a particular deal, which was 290. There is an 18-lock maximum, open to change. This indicates that the lock limit would be triggered by a single-day shift to 308 or 272. 

(290 + 18 = 308; 290 - 18 = 272)

Trading is prohibited above 308 if the market moves to its maximum. Trading is prohibited below 272 if the market moves to its minimum.

Additionally, some futures have variable or expanded boundaries. This indicates that the limit will be increased the following day if numerous contracts for various months change the limit.

For example, suppose the expanded maximum is 50%, which raises the limit to 27 the following day. 

(18 × (1 + 0.5) = 27)

If the market's limit were set at 300, the limit down price the following day would be 273, and the limit up price would be 327. 

(300 - 27 = 273; 300 + 27 = 317)

If the price moves the limit up or down once more, the limit remains at the enlarged rate; otherwise, it shrinks back to 18. To trade around a lock limit situation, some traders will use options or exchange-traded funds (ETFs) if they are accessible.

Example of a Lock Limit

Suppose a commodities trader is interested in knowing the restrictions based on the current price because a significant news release is scheduled for today. The limit is 20, which is subject to change over time but is 20 at the time of the transaction based on the current price.

Assume that the price of this commodity is 320. Accordingly, the price limit on the upside is 340, and the price limit on the negative is 300. 

(320 + 20 = 340; 320 - 20 = 300)

The expanded maximum for this commodity is 30. This is also open to change, but at the time of the transaction, the expanded limit was 30, which means that only if the commodity settles at the limit up or down price today will this limit take effect tomorrow. 

(20 × (1 + 0.5) = 30)

Considering that the speculator owns commodities futures at 315, let's assume they are interested.

When bad news is announced, the price decreases to 300 right away. There is no trading below the current boundary of the market. Additionally, it implies that the trader is unable to exit their position.

Even if they attempt to sell at 300, they probably won't find any takers. If so, the price may rise and shift away from the limit-down price. If contracts for various months resolve the limit, the new limit is 30 the following day. Thus, the new lower maximum is 270. 

(300 - 30 = 270) 

Our trader can lose their account when the price opens at 300. The expanded limit is still in place if the market drops further and settles at 270, and the limit down the following day is 240. 

(270 - 30 = 270)

The 20 limit is reinstated above and below the closing price if the price ends above 270 and below 330 (300 + 30 = 330), indicating that the expanded limit has not been reached.

Advantages of Lock Limit

Lock limits offer several benefits in financial markets, providing stability and reducing volatility through controlled trading parameters. Some of them include: 

1. Price Stability

Lock limits can help stabilize prices by preventing extreme fluctuations in the price of a security. This can provide a sense of security to investors by avoiding sudden and drastic price movements.

2. Reduced Volatility

By restricting trading within a certain price range, lock limits can reduce market volatility. This can benefit both investors and market participants by creating a more orderly trading environment.

3. Time for Decision Making

Lock limits give investors time to reassess their positions and make informed decisions. This can prevent knee-jerk reactions to sudden market movements and promote rational decision-making.

4. Protection Against Panic Selling

Lock limits can protect against panic selling by preventing investors from immediately selling their shares at significantly lower prices during times of market stress. This can help prevent market crashes and systemic risks.

Disadvantages of Lock Limit

Despite their intended benefits, lock limits also come with certain drawbacks that can impact market dynamics and trading strategies. Some of the drawbacks are as follows: 

1. Lack of Liquidity

Lock limits can reduce liquidity in the market, as they restrict the ability of investors to buy or sell securities within the specified price range. This can make it difficult for investors to enter or exit positions, especially during times of high volatility.

2. Market Inefficiency

Lock limits can lead to market inefficiencies by preventing prices from accurately reflecting supply and demand dynamics. This can result in mispricing of securities and hinder price discovery.

3. Delayed Reaction

Lock limits can delay the market's reaction to new information or events, as trading is temporarily halted when the limit is reached. This can lead to delayed adjustments in prices and potentially distort market signals.

4. Risk of Gaps

When trading resumes after a lock limit is lifted, there is a risk of price gaps between the limit price and the next available price. This can result in significant losses or gains for investors depending on their positions.

Conclusion

Lock limits play a crucial role in maintaining market stability and preventing extreme price fluctuations in both futures and stock markets. While they serve as effective mechanisms for controlling volatility and ensuring orderly trading, they also come with complexities and potential limitations.

As markets continue to evolve, regulators and exchanges will likely refine and adapt lock limit mechanisms to address emerging challenges and maintain market integrity.

Lock limits are integral components of market regulation, designed to mitigate the risks associated with excessive volatility and abrupt price movements. 

Additionally, the effectiveness of lock limits may vary across different markets and instruments, raising concerns about their uniform application and impact on market efficiency.

Some critics argue that traditional lock limit mechanisms may not adequately address the complexities of electronic trading and high-frequency markets, leading to calls for alternative approaches or supplementary measures.

Consequently, regulators and exchanges may explore innovative solutions, such as dynamic circuit breakers or real-time monitoring systems, to enhance market resilience and responsiveness.

As financial markets continue to evolve to new realities, policymakers and market participants must remain vigilant in assessing the effectiveness of lock limit mechanisms and exploring strategies to ensure the stability, efficiency, and integrity of global financial markets.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Algorithm Trading
• Arbitrage
• Bid and Ask
• Limit Down
• Limit Up