In this article, we'll take a deep dive into what is a circuit breaker in the stock market. We'll explain the causes, potential outcomes, and ways to trade them. Concerns and controversies surround these potential fail-safe measures. After finishing this article, you will better understand them.
What is a circuit breaker?
If you've ever found yourself in a frantic and highly volatile market or stock and noticed that all the quotes are suddenly frozen and charts don't update, you have experienced a halt triggered by a circuit breaker.
Your first thought may be that your internet connection is down, but other online apps work fine. Circuit breakers are a security measure automatically implemented when specific price or volatility parameters get triggered. They are critical to helping financial markets maintain stability during extreme volatility.
Circuit breakers can be implemented across all U.S. stock exchanges and stocks. Circuit breakers exist to ensure the market has adequate liquidity to complete and execute trades. Circuit breakers become particularly important with high-frequency trading, which allows trades to be executed in milliseconds. High-frequency trading has added to market volatility. Let's take a look at what is a circuit break in stock market trading.
Circuit breakers halt trading when markets or stocks fall or rise past a certain percentage threshold for the day or within a specified period.
A key feature of circuit breakers is threshold triggers. These triggers can differ between exchanges, but the intent remains the same: to calm the market, let cooler heads prevail, and ensure liquidity before the security or exchange reopens.
For example, the New York Stock Exchange (NYSE) has market-wide circuit breakers (MWCB) that automatically trigger if the S&P 500 index is beyond a 7% threshold, which is the level 1 threshold. Trading is halted on the exchange for 15 minutes. We'll get into the specifics of each exchange and the trigger thresholds shortly.
Types of circuit breakers
There are two types of circuit breakers: Market-wide circuit breakers (MWCB) and Limit Up-Limit Down (LULD) individual stock circuit breakers.
MWCBs are price-based and cause complete stock exchanges to halt trading, which includes all national market system (NMS) securities trading on the exchange. These circuit breakers trigger when the benchmark index drops a certain percentage throughout the day. The NYSE, AMEX and NASDAQ have 3 levels of MWCBs.
- A Level 1 MWCB halt triggers when the S&P 500 index falls 7% below the prior day's closing price from 9:30 a.m. to 3:24 p.m. EST each trading day. When triggered, it results in a minimum 15-minute trading halt. A Level 1 MWCB can only be triggered once during the trading day.
- A Level 2 MWCB halt triggers when the S&P 500 index falls 13% between 9:30 a.m. to 3:24 p.m. EST. A Level 2 MWCB can only be triggered once during the day.
- A Level 3 MWCB halt triggers when the S&P 500 index falls 20%. A Level 3 can trigger a market-wide trading halt for the rest of the day.
At or after 3:25 p.m. EST, Level 1 and Level 2 circuit breaks do not trigger a market-wide trading halt. Level 3 triggers a halt for the rest of the trading day anytime between 9:30 a.m. EST and 4 p.m. EST.
LULD individual stock circuit breakers are triggered on volatility, which includes a price and time threshold. Individual stock circuit breaks can be triggered on the way down but also on the way up as well.
National market system (NMS) securities are categorized as Tier 1 and Tier 2. Tier 1 stocks include all securities in the S&P 500, the Russell 100 and select exchange-traded products. Tier 2 includes the rest of the stocks except for warrants and rights.
How do circuit breakers work?
Circuit breakers automatically halt trading when prices surpass a percentage threshold based on the prior day's close within a specific period. Circuit breakers are often applied when indexes drop by a certain percentage. However, stocks can have upside volatility circuit breakers.
The U.S. Securities and Exchange (SEC) approved LULD circuit breakers in October 2013 after the events of the "flash crash" on May 6, 2010. At that time, the Dow Jones Industrial Average (DJIA) dropped 1,000 points, which 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.
For LULD individual stocks, the percentage drop or up is accompanied by a specific period. It's a volatility moderator designed to cut down on large and sudden stock price moves. It prevents stocks from trading above and below a specific price band. The price band is a percentage above and below the average price over the immediately preceding five-minute trading period.
The price band thresholds are 5%, 10% and 20% or the lesser of 15 cents or 75%, depending on the stock prices and if it's a Tier 1 or Tier 2 stock. A five-minute halt is applied when an LULD triggers.
Here's a step-by-step explanation of the events that occur when circuit breakers are triggered.
- Step 1: Circuit breaker triggers on price or volatility thresholds being hit. A circuit break gets triggered when an index or stock price hits or exceeds the MWCB or LULD thresholds. Extreme price or volatility moves can happen from news events, economic reports, rumors, and even market manipulation. The cause of this doesn't matter.
- Step 2: Trading is halted. Trading in the markets is halted for a period ranging from five minutes for LULD triggers and 15 minutes or more for MWCB and for the rest of the day if a Level 3 MWCB is triggered. Individual stocks are halted for LULD triggers, and all stocks are halted on MWCB triggers.
- Step 3: Market regulators and exchanges investigate the situation. Market regulators and stock exchanges monitor and assess the situations with the trading halt. Once cleared, the market is set to resume.
- Step 4: Trading is resumed. Upon clearance by regulators, stock exchanges and stocks resume trading. Prices can also gap up or down upon trading resumption to counter excessive buying or selling pressure.
Market regulators and exchanges play important roles in the stock market and implementing and enforcing circuit breakers. The intent is to curb panic selling or buying in stock under extreme volatility. Regulators and exchanges can halt trading for longer periods of time if they warrant a longer cooling-off period to attempt to ensure market stability.
Understanding stock market volatility
Stock markets have volatility and risk. Volatility is measured by how much a stock market or individual stock moves up and down over a period of time. The standard deviation of returns is a statistical measure of the amount of variance from the average. A high standard deviation indicates more volatility and a low standard deviation indicates less.
For stock markets, the volatility index known as the VIX measures the expected or implied volatility of the S&P 500 for the next 30 days. A high VIX indicates expectations for high volatility over the next 30 days and vice versa, with low volatility for a low VIX.
For individual stocks, the Beta is a measure of the volatility of a security concerning the overall market, notably the S&P 500 index. A reading of 1.0 indicates the stock is expected to move in line with the overall market. A reading above 1 indicates the stock is expected to move more than the market. A reading of less than 1.0 indicates the stock will be more than the market.
For example, if XYZ has a beta ready of 2.0, it should move 2X the overall market. If the S&P 500 index increases by 2%, XYZ should increase by 4%. If XYZ has a reading of 0.50, then it indicates that it should move only half as much as the S&P 500 index. If the S&P 500 index is up 2%, XYZ should be up 1%. These are theoretical, as the reality can differ on any given day.
The role of circuit breakers
Circuit breakers are a fail-safe intended to curb panic selling and take a "time out" for cooler heads to prevail. The need for circuit breakers came following the Black Monday stock market crash in 1987, the largest one-day stock market loss in history. The SEC created circuit breaker rules the following year, in 1988. They are designed to curb panic selling, giving investors time to contemplate the situation and attempt to make more rational decisions concerning their positions.
That being said, circuit breakers continue to be a work in progress. They have been refined through the years, and each market crash tends to bring about new refinements.
Pros and cons of circuit breakers
There are two types of circuit breaks: MWCB and LULD. MWCB applies to all stocks, and LULD applies to individual stocks. Here are the pros and cons of circuit breakers.
The pros include:
- Prevent panic selling. The trading halt allows market participants to take a breather and assess the situation. It prevents panic selling driven sheerly by emotions. Since trading is halted, participants can't physically sell or buy stock until trading resumes.
- Protect investors. The halting of trading stops stocks from further crashing since transactions are paused. Investors can't lose money more money while stocks are halted.
- Maintain market stability. By halting trading, participants can assess the situation without fear of further slides during the halt. The temporary halt stabilizes the markets from crashing even further, and trading is halted.
The cons include:
- Don't enable a free market. By halting trading, circuit breakers prevent sellers from being able to sell and buyers to provide liquidity. It's artificially and temporarily pausing what a free market should be left alone to do. Circuit breakers delay what free markets will inevitably do.
- Cause more panic after trading resumes. The anxiety of a trading halt can build up into a panic about being the first to unload stock after trading resumes. For this reason, stocks tend to resume trading with a gap that can be against your position.
- Price gaps can be painful. Circuit breakers trigger a trading halt. During the halt, specialists and market makers assess the selling pressure and apply the appropriate price gaps to achieve price equilibrium on the open. Often, the price is gapped down so much that investors and institutions may opt to wait to sell on a rebound.
Circuit breakers around the world
Circuit breakers exist in stock markets around the world. A global contagion can trigger circuit breakers systematically around the world’s largest stock exchanges to help prevent a systemic meltdown. The 7% trigger is common with most larger liquid stock exchanges.
- The U.S. stock market Level 1 MCWB triggers when the S&P 500 index falls 7%.
- The Tokyo Stock Exchange triggers a circuit breaker halt in Japan for 30 minutes when the Nikkei 225 index falls by 7%.
- In the U.K., the London Stock Exchange circuit breaker triggers a halt when the FTSE 100 drops 7%.
- In China, the Shanghai Stock Exchange also triggers a 30-minute trading halt if it drops 7%.
- In Hong Kong, the Hong Kong Stock Exchange triggers a 30-minute trading halt when it drops 5%.
- In Canada, the Toronto Stock Exchange has a single stock circuit breaker that halts trading for five minutes when a stock moves up or down by 10% within five minutes.
Notable circuit breaker events
The notable historic events related to circuit breakers helped to shape the current parameters and templates for future situations. The creation of circuit breakers came from the need to prevent another Black Monday. The Black Monday stock market crash of Oct. 19, 1987, saw the Dow Jones Industrial Average collapse 23%. This spawned the need for a mechanism to pause the markets during unthinkable extreme volatility.
The evolution of circuit breakers
The SEC created the first set of circuit breaker guidelines in 1988. The 2010 flash crash prompted the addition of the LULD circuit breaker rules for individual stocks. Circuit breakers were triggered on Oct. 27, 1997. They have been revised and updated several times to evolve into the 2013 circuit breaker rules based on the S&P 500 index.
During the COVID-19 pandemic, MWCB circuit breakers were triggered on Feb. 27, 2020, as stock markets collapsed in fear of contagion. They triggered again on March 9, 2020, and March 12, 2020, ahead of the pandemic lows, which kicked off a rally to new all-time highs in the coming year.
Criticisms and controversies
While circuit breakers intend to put the brakes on a volatile situation, many critics feel they cause more harm than good. A trading halt resumption often results in an unfair gap up or down with no recourse to react until afterward. This is the most unfair part of trading halts. The market makers argue that the trading halts allow them to balance out the buyers and sellers to discover price points to find equilibrium.
A trading halt would occur in a perfect world and resume at the same prices, but that's impossible. Critics argue that it gives market makers and specialists an unfair advantage, and shareholders get the short end of the stick. Traders argue that volatility is part of a free market and that exchanges should let the markets operate as they naturally do. Let the market decide when the selling is too much as buyers put in the floor. Many view circuit breakers and trading halts as artificial interventions that don't help the situation but create more volatility.
Circuit breakers and market psychology
Fear and greed are the two emotions that dominate the stock market. Circuit breakers aim to calm the markets and curb panic selling. However, they can also stir more panic. Whenever a trading halt occurs, it locks people out of their positions, which can generate more panic on the reopening. It's like being forced underwater to hold your breath until you can surface.
The other problem with a trading halt is the inability to avoid the price gaps. Anxiety and tension can stir fear and greed. Market makers and specialists attempt to anticipate this when pricing in the price gap is down. They are attempting to dissuade sellers from panicking at too much of a loss and presenting prices that buyers may find too cheap to pass up.
Recent developments and future trends
Circuit breakers are evolving to be more responsive to real-time market conditions. Implementing artificial intelligence (AI) and machine learning (ML) can enable circuit breakers to trigger more accurately and promptly to avoid the impact of panic selling and mitigate system market shocks. Sophisticated AI can create new dynamic algorithms to respond more to market conditions.
Circuit breakers are evolving from cross-market to cross-asset so that multi-asset classes can be halted simultaneously to prevent a ripple effect. Since more and more markets get coupled and become increasingly interconnected, cross-asset circuit breakers can help to deter the spread of financial contagion. Cryptocurrencies are another asset class that needs circuit breakers as massive rug pulls happened, like the 53% single-day drop in Bitcoin on May 19, 2021.
Trading circuit breaker halts
While each circuit breaker halt is unique unto itself, historically, some reaction templates have followed. Upon a trading halt resumption, stocks unusually tend to go the opposite way of the halt, especially after a price gap. If a stock has a LULD halt on a spike, you can consider watching for short sell levels to consider a short, but this is riskier than playing gap-down trading halts.
The best way to play a reversal bounce is to place many "wish" bids at extreme levels to increase the chances of attaining a fill and getting a better average price should the stock gap drop dramatically. Make sure to have a trading methodology. This should include price indicators like moving averages, Bollinger Bands and momentum indicators like a relative strength index (RSI) oscillator on small intraday time frames like the 1-minute and 5-minute. It also helps to know the trend price support and resistance levels. Using wider time frames with well-known patterns like the golden cross and death cross can also give you price inflection points to consider placing your trades.
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