What Is the Role of a Floor Mechanism in Stocks?
A floor mechanism in stocks prevents further trading of a stock if stock prices drop below a certain threshold. There are floor mechanisms that apply to a single stock, and floor mechanisms that apply to all stocks on a stock exchange. The purpose of the floor mechanism is to prevent financial panics. If a stock's value drops too quickly, everyone who holds that stock will immediately try to sell it, which can destabilize the stock market and lead to panic sales of other securities.
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Last Trade
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For individual stocks, there are different thresholds for the floor mechanism, which depend on the previous trade price of the stock. According to the Securities and Exchange Commission, the limit is 10 percent of the value of the stock if the previous price was $25 or lower, and 3 percent of stock value if the previous trade price was over $50. The stock exchange uses the consolidated price to establish the previous trade price, which includes sales and purchases by all traders.
Shutdown
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A stock exchange can also establish a floor mechanism that applies to every stock that trades on the exchange. This type of floor mechanism uses a stock index, such as the Dow Jones Index or the S & P 500. If the index price drops a large amount during a short period of time, the stock exchange uses a circuit breaker to stop all trading on the exchange for a certain period. This situation is known as limit down.
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Market Makers
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A floor mechanism requires a market maker to offer stocks at a price that is close to the market price. A market maker in the stock market is a stockbroker who will buy stocks from traders or sell stocks to traders at publicly quoted prices at any time while the stock exchange is open, which provides market liquidity. According to the Securities and Exchange Commission, if a market maker doesn't want to buy back a stock from a client at a certain time, such as a few seconds after the government announces the monthly unemployment numbers or the central bank sets new interest rates, the market maker provides a stub quote, which is an unrealistically low price for the stock such as 1 cent. Stub quotes violate the floor mechanism, and a trade that occurs at the stub quote price can be reversed by financial regulators.
Unlisted Stock
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A floor mechanism only applies to stocks which are listed on a stock exchange. An unlisted stock trades over the counter, so traders make direct transfers without the involvement of a stock exchange. The price of an unlisted stock can drop by a larger amount in one day, because there are no stock exchange rules to establish a maximum price decline.
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