The Role of Circuit Breakers
In a broad sense, circuit breakers are those measures instituted by stock exchanges that are purposely aimed at halting trading for a temporary period. These measures are instituted when there is a fall in the market by a certain percentage and in a certain specific period.
This halt can even last the entire trading day. A halt in trading is necessary when there is excess volatility and huge price swings in individual securities. Rampant panic selling on the stock exchange also necessitates circuit breaking.
A History of Circuit Breaking
The history of circuit breaking can be traced back to October 1987. In that year, there was a market crash which led to the ultimate fall of the Dow Jones Industrial average by 22.6% in just a day. This crash is what is commonly referred in financial lingo as ‘The Black Monday’. Black Monday started in Hong Kong and eventually spread to markets globally.
Another occurrence that affected the Dow Jones was in May 2010 where it lost more than 9% in just a span of ten minutes, hence referred to as the ‘flash crash’.
In essence, a substantial decline in the Dow Jones Industrial Average is what necessitates a circuit break. Over the years, there have been different trigger points which correlate with the value of the Dow Jones at the time. Each trigger point is re-adjusted to correspond to the present value.
One of the factors that greatly influences the duration of the circuit break is the size of the drop. The larger the drop, the longer the duration of the circuit break. In normal practice, a 10% drop would justify a one-hour circuit break.
On the extreme, a 30% drop would cease trading in a day.
The specific time of day in which a drop occurs presents another factor that would affect the duration of the circuit break. A rough guide was formulated by various organizations to inform the duration of a trade halt at different times of the day.
A quick overview of such a guide from the NYSE is as follows:
From the above table, we can deduce that a 10% drop before 1 pm, which is a level 1 halt, in the Dow Jones, will inevitably bring a 1 hr halt to the market. A 20% drop (level 2 halt), before 1 pm will bring a 2 hr halt whereas a 30% drop (level 3 halt) will bring the market to a close.
It is worth noting that trade halts are not purely as a result of declines in the Dow Jones. Major events can also cause trade halts. A case in point is the 9/11 terrorist ordeal which halted trading for a whole week despite the Dow Jones not reaching a 10% drop.
In contemporary time, circuit breakers have been classified into market-wide circuit breakers and single-stock circuit breakers. Market-wide circuit breakers come into effect due to declines in the S&P 500 Index.
The trigger points are 7%, 13% and 20% which represent level 1, 2 and 3 halts respectively. The duration of each halt is as follows: Level 1 duration is 15 minutes for drops that that occur before 3:25 pm, Level 2 duration is 15 minutes for drops that occur before 3:25 pm and lastly level 3 ceases trading for the duration of the whole day for any decline that occurs at any time of the day.
Single stock Circuit breakers, on the other hand, come into effect regardless of upward and downward shifts in price. As far as single stock circuit breakers are concerned, the Securities and Exchange Commission uses a mechanism hereby referred to as ‘limit up limit down’.
The up and down movement out of certain predetermined bands are what trigger the halts. Trading outside the predetermined bands for a period of 15 seconds results in the halt of trading for a period of five minutes. The maximum halt limit is set to 10 minutes. The predetermined bands are then increased to twice the previous value at the opening and closing periods of the trading day.
Therefore, we can conclude that circuit breakers are pauses in trading after an index drops by a certain percentage. It averts panic selling and enables investors to think through their next move instead of making impulsive decisions.