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Stock Market - What is a circuit breaker?

Posted on Wednesday, March 11th, 2020 by MarketBeat Staff

Stock Market - What is a circuit breaker?

Circuit breakers are a security measure that has been put in place by the Securities & Exchange Commission (SEC) as an effort to reduce panic-selling on U.S. stock exchanges. They apply to broad market indices such as the Dow Jones Industrial Average (DJIA), the NASDAQ, and the S&P 500.

A circuit breaker is triggered by temporarily halting trading when prices hit predefined levels. An example of this occurred on March 9, 2020 when trading on all major indexes was stopped for 15 minutes because every major exchange had dropped below 7%.

There are three levels of circuit breakers. If a Level 1 or Level 2 event occurs trading is suspended for 15 minutes unless it is after 3:25 EST in which case trading is allowed to continue. In the worst-case scenario, a market or security decline of 20%, trading for that index or security is suspended for the remainder of the trading session.

Circuit breakers exist to ensure the market has adequate liquidity to complete and execute trades. This is becoming particularly important with high-frequency trading which allows trades to be executed in milliseconds. Although high-frequency trading is generally considered to be a benefit to markets, there is little doubt that it has added to market volatility.

Whether or not circuit breakers are effective or not will continue to be debated. Perhaps the best reason to believe they work is that they are not used that much, which means that their very existence acts as a regulation in and of itself.

Introduction

On March 9, 2020 trading was halted for 15 minutes after only a few minutes of the markets opening. The reason was that every major exchange had plunged below 7%. This triggered what is known as a circuit breaker.

Volatility is a natural if a bit uncomfortable reality of investing. It can relates to an individual stock or industry. Or, when you have an event such as the financial crisis of 2007 or the coronavirus of 2020, it can affect the entire market.

One such event occurred in October of 1987. On a day known as “Black Monday”, the Dow Jones Industrial Average (i.e. the Dow) plunged 508 points in a single day. At the time, a drop of that magnitude was 22.6% of the index’s value.

This event, which spooked investors with visions of the market crash of 1929 prompted regulators to put in place circuit breakers. Continue reading to learn more about what circuit breakers are and why they’re important to ensure the safety and stability of our global markets.

What is a circuit breaker?

When many people hear the term circuit breaker, they think of a safety device used in modern electrical systems. These devices will shut down electricity to a specific area if the breaker has too much stress on it (i.e. it will break the circuit). Circuit breakers exist to protect individuals from the dangers of faulty wiring. Understanding this definition is helpful to understanding the role of a circuit breaker in the stock market.

The circuit breaker is a mechanism (not an actual device) in which trading is stopped for a period of time if the stock price of an individual security or an entire index falls below certain pre-established boundaries (or levels).

There are currently three levels of circuit breakers, each resulting in a specific market action:

Level 1 – a 7% decline below the previous closing price

Level 2 – a 13% decline below the previous closing price

Level 3 - a 20% decline below the previous closing price

If a Level 1 or Level 2 circuit breaker is triggered, the result is an immediate suspension of trading for 15 minutes. An exception occurs after 3:25 p.m. After that time, trading is allowed to continue. If a Level 3 circuit breaker is triggered, trading will be halted for the remainder of the trading day.

An important thing to remember about circuit breakers is that when they relate to a broader index (the DJIA, NASDAQ, S&P 500, etc.) they only come in on downward price movement. Circuit breakers also exist for individual securities and they will be triggered whether the price of a security moves up or down.

Why are circuit breakers significant?

In practical terms, circuit breakers exist to ensure that individual stocks or markets have appropriate liquidity.

On a broad level, circuit breakers exist to provide a safety net for investors. With the assurance of an orderly pullback or correction in the markets, investors can have a level of assurance that they otherwise would not have. If investors panic, they may begin to issue limit orders which can be difficult to fill. To combat this, the circuit breakers create a “cooling off” period where trades can be batched.

Circuit breakers are particularly important with the rise of high-frequency trading. Today trades are done in milliseconds. While this affects the price of individual securities far more than the broader market, it’s not hard to see how high-speed trading can cause markets to swing sharply and swiftly in either direction. However, this can lead to a price that falls to levels that are at odds with its fundamentals. Allowing orders to accumulate and be executed as a batch can, in theory, lead to higher quality execution prices, which will reduce volatility.

Because market volatility is usually preceded by some bit of news, circuit breakers can allow investors time to digest this news and develop a trading strategy.

What is the limit-up limit-down rule?

The event of March 9, 2020 was the first, successful, time circuit breakers were used. During the “flash crash” on May 6, 2010 the Dow Jones Industrial Average (DJIA) dropped 1,000 points, which at the time was a drop of over 9%, in just 10 minutes. However, the market circuit breakers set in place did not kick in. One potential reason for the crash that is still being debated is the emergence of high-frequency trading.

This prompted regulators to update the parameters for the circuit breakers. In October 2013, the Securities & Exchange Commission (SEC) instituted a limit-up limit-down rule to determine the threshold for acceptable trading at various times in the trading day.

This led to the following table which is used to regulate individual securities. Circuit breakers will kick in if trading occurs outside of these parameters.

Acceptable up-or-down trading range (9:45 a.m. – 3:35 p.m.)

Acceptable up-or-down trading range (9:30-9:45 a.m. and 3:35-4:00 p.m.)

Security price, listing

5%

10%

Tier 1 securities as defined by the National Market System. This includes S&P 500 and Russell 1000-listed stocks, as well as some exchange-traded products priced greater than $3.00

10%

20%

Tier 2 securities as defined by the National Market System that are priced over $3.00.

20%

40%

Other stocks that are priced greater than or equal to $0.75 and less than $3.00

Lesser of 75% or $0.15

Lesser of 150% (upper limit only) or $0.30

Other stocks priced less than $0.75

 

If trading outside of these bands continues for 15 seconds, trading stops for five minutes. At this point, a new reference price is calculated using the average price for the previous five minutes. The maximum allowed pause is 10 minutes.

Are circuit breakers helpful or harmful?

The evidence circuit breakers being helpful or harmful may be best summed up by the idea that circuit breakers are infrequently triggered. Some of that may be simply because the existence of the circuit breakers adds as a break to volatility. However, that is hard to quantify. To the extent that circuit breakers add a level of confidence for investors, they can be seen as a good sign.

According to Mason Gerety, professor emeritus at Northern Arizona University who was also a former research economist at the SEC said of circuit breakers, “There was this idea that if you stopped trading and gave a pause, then people would calm down and it might stabilize the markets.”

However, Gentry also found, in research conducted in the 1990s that the existence of circuit breakers can be a self-fulfilling prophecy. “The fact that there’s a circuit breaker might actually be more likely to get you to the circuit breaker,” said Gerety. “It’s kind of almost like a gravitational pull.”

The bottom line on circuit breakers

In a free market, it’s extremely important for investors to have confidence in the markets. Circuit breakers are one measure that the SEC has adopted to help reduce panic selling and allowing the market to retain the liquidity it needs.

The need for such measures was made evident after the “Black Monday” crash in October of 1987 when the Dow dropped over 20% in a single session. Over the years, the circuit breaker system has been modified to reflect the dynamic nature of trading including the emergence of high-frequency trading.

Circuit breakers apply to individual securities as well as market indexes. A fundamental difference between the two types of breakers is that circuit breakers that are tied to a market index are only triggered by downward price movement. For individual securities, circuit breakers are activated by either upward or downward price movement.

 

 


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