Circuit Breaker in Stock Market

A Circuit Breaker in the stock market (also called a market curb) is nothing but a break (i.e., a temporary slowdown) in the circuit (i.e., trading in the market), which is used to prevent panic-selling of stocks within a very short period (say within minutes or hours) and stops the trading for a specified period, so that accurate information flows over the market within that time-frame, thereby preventing speculative gains & irrational losses.

During the sudden drop or fall in the stock market, the entire market witnesses a turmoil, thereby affecting the trading activities negatively. Through circuit breakers, the market tries to stabilize and allow the stock market to be normal and not get affected by the sudden fall in the prices, which leads to panic selling of stocks.

A circuit breaker in stock market facilitates a mechanism to keep the market stable in the event of steep fall in the stock prices, leading to panic selling of the same within a specific period. This market decline is reflected through the drop observed in the S&P 500 Index while the regular trading hours are on from 9.30 to 16.00 EST or until 13.00 in case of half-day trading. The opening price of the current day is compared to the closing price of the previous trading day to check the decline and proceed with implementing circuit breakers.

It is named so as it acts as a circuit breaker in the electricity-driven scenarios, where the electricians control or stop the flow of power temporarily in the event of surge. It acts as a safety mechanism in such scenarios. Similarly, a circuit breaker in the stock market puts trading on hold for a temporary period so that the panic selling, which seems to be the only solution to traders to get rid of the losses, does not occur and the market gets time to stabilize.

Say a stock is trading at $500. Suppose all of a sudden, and all the investors start selling their invested stocks. It will eventually fall by the law of demand, say $ 65 in just five days. It may fall at such a low that the price does not even reflect its fundamental value (i.e., the minimum should be the price of the stock derived by observing the financial statement of the company, its growth perspective, its potential future revenue & many factors).

The problem that arises is that the new investors see the company in a negative sense by ignoring the fundamentals of the company. In the long run (i.e., in years), the stock prices will fall if the fundamentals are weak. It should not happen.

A similar story applies to the stock market as a whole. It helps curb the irrational panic selling of the investors. It allows the investor to take a break – think about the stock, whether it is the right time to trade – and then decide. So, they pause the trading game for a brief time.

The US introduced the first market-wide circuit breaker in 1987 when the Dow Jones Industrial Average (DJIA) observed a massive decline of 22% in just one day. It was a significant loss.

Later in February 2013, new rules for market-wide circuit breakers were introduced by SEC (Securities & Exchange Commission) & the S&P 500 Index was chosen as a new benchmark for circuit breakers. Thus, the index's previous day's closing price is used to calculate the percentage decline.

It prevents the downside; there is also a concept of circuit filters, which prevent an unreasonable upsurge in the stock prices due to “panic-buying.” Time being, let`s only focus on circuit breakers.

The basic intention of circuit breakers is to pause the panic-selling button. They apply to both individual stocks as well as market indices. There are three levels of circuit breakers:

Level #1

It is the first breaker automatically placed by the exchange when the stock falls by a specified percentage from the last close price. At this point, the trading is halted for a few minutes & then it resumes.

Level #2

The second breaker is triggered when the stock price or the index again falls with a higher percentage (here, the percentage of the downfall is calculated concerning the closing price of the last day). At this point, the trading is halted for the same amount of time as in the level 1 breaker & then it is allowed to resume again.

Level #3

It is the third & final circuit breaker if the stock price or index continues to fall with a larger percentage than in the level 2 breaker. Here, the percentage of downfall is calculated concerning the closing price or value at which the last day was closed. If level 3 of the circuit is placed, there is no resuming back – the trading is stopped for the remainder of the day. It opens directly on the next market day.

If a Level 1 or Level 2 circuit breaker is triggered before 3:25 pm, the market halts trading for 15 minutes. However, if circuit breakers get triggered after 3:25 pm, there is no halt in the market trading. On the other hand, if a Level 3 circuit breaker gets triggered at any point in time during the said trading day, the market halts for the remainder of the trading day. So, you can see there is no upper limit for the level 3 circuit breaker.

The circuit breakers are placed one by one as shown below:

Limit Up and Limit Down (LULD) define the limits that help keep the market calm. The US Securities and Exchange Commission (SEC) also introduced circuit breakers for individual securities with the same purpose to prevent excessive excess volatility in the trading of those stocks.

Here, they are called bands, which get triggered depending upon percentage change concerning the average price for the last 5-minute period of trading. The traders and investors are expected to follow the percentage defined by each band and not go beyond the limits specified by it.

The band limits are as follows:

The bands get triggered if the price of the security changes above the limits & does not restore the limit within 15 seconds of the triggering event. The trading is halted for 5 minutes.

The trading halt means a pause in the trading as specified by the exchange regulator. So, SEC has specified the trading halts as follows:

Let us consider the following instances to understand why and how the concept of circuit breaker in stock market applies:

Example #1

The Covid-19 pandemic has caused the US markets to fall sharply. In the US, there is also the downfall of only global indices.

The circuit breaker was placed on March 9, 2020, when the S&P Index fell from 2971 to 2778 within a few seconds of the opening of the index. The US Stock market has fallen by 193 points after it touched 2778. Trading was then halted for 15 minutes. There was no level 2 or level 3 circuit on that day.

Again, on March 12, 2020, the S&P 500 Index witnessed the circuit breaker. The market observed a level 1 circuit breaker when the index fell from 2738 to 2516. The trading was halted for 15 minutes. There was no level 2 or level 3 circuit on that day.

Example #2

In February 2023, Istanbul stock market witnessed implementation of circuit breakers too frequently, i.e., consecutively second time on Feb 7 (Tuesday). The BIST 100 Index was down to approximately 7 percent, leading to panic selling of stocks. This event occurred after an earthquake hit Turkey and Syria. A day before, i.e. February 6 (Monday), circuit breakers were implemented seeing the drop up to 5%.

The magnitude of the earthquake was 7.8 unit, and it struck the regions on February 6, continuing the effects to February 7. This shows how national calamities also trigger circuit breakers in the stock market.

Though circuit breakers have been found effectively working in controlling the panic state in the stock market, they have been criticized by many for being disruptive. The limits of the circuit breaker decreases liquidity in the market. The critics believe that of these breakers do not put trading on hold, and the activities continued, it would be more beneficial in establishing a consistent equilibrium.

Also, there have been reports that have claimed that whether a circuit breaker is implemented in the stock market or not, the market still remains vulnerable.