Studying Circuit Breakers in Trading
Circuit breakers are temporary measures used in stock exchanges to prevent panic-selling. In the US, there are three levels of circuit breakers based on the drop in the S&P 500 Index: 7%, 13%, and 20%. These levels are designed to halt trading. Circuit breakers can be triggered for individual securities regardless of price direction. The circuit breaker system has been revised based on past crises, with the first one introduced after a 23% drop in the Dow Jones Industrial Average on October 19, 1987.
Basics
Circuit breakers are regulatory measures used during emergencies to temporarily pause trading on exchanges. Their purpose is to prevent panic-selling which can also be triggered during excessive buying. These measures are applied to individual securities and market indexes, such as the S&P 500. Circuit breakers operate automatically and halt trading when prices reach predetermined levels in exchanges worldwide.
How Do Circuit Breakers Work?
Circuit breakers function similarly to their electrical counterparts at home, but in the trading world, they serve as emergency measures implemented by stock markets. When market prices experience a significant decline, these circuit breakers temporarily halt trading or close it for the rest of the trading day. This applies to both individual securities and market indexes. Since February 2013, market-wide circuit breakers have been in place to respond to single-day declines in the S&P 500 index. A Level 1 decline occurs when the index falls 7% below its previous close, while a Level 2 decline represents a drop of 13%. A Level 3 decline indicates a drop of 20%. These levels have remained unchanged as of March 2022.
Level 1 or 2 circuit breakers pause trading across all exchanges for 15 minutes, except if triggered at or after 3:25 PM, in which case trading continues. On the other hand, Level 3 circuit breakers halt trading for the rest of the trading day, which is from 9:30 a.m. to 4:00 p.m. Unlike market-wide circuit breakers, circuit breakers for individual securities are triggered regardless of whether the price moves up or down. Exchange-traded funds (ETFs) are considered individual securities under the circuit breaker system, even though they represent portfolios of multiple securities. Since all securities are halted when specific levels are triggered, they are referred to as market-wide circuit breakers.
Regulating Individual Securities Through Trading Range Thresholds
The current circuit breaker system regulates individual securities based on acceptable trading ranges, as shown in the table below. If trading activity persists outside of these ranges for 15 seconds, it is halted for five minutes. The reference price is determined using the average price over the previous five minutes, but the maximum pause allowed is 10 minutes.
To account for higher trading volumes during the opening and closing periods of the trading day, the bands are doubled for the last 25 minutes. The U.S. Securities and Exchange Commission (SEC) implemented this system. It is known as the limit-up limit-down (LULD) mechanism, which sets thresholds for acceptable trading based on the security's price and listing.
Circuit Breaker System Parameters
Acceptable up-or-down trading range (9:30 am-3:35 pm) | Acceptable up-or-down trading range (3:35-4:00 pm) | Security price, listing |
| 5% | 10% | Tier 1 National Market System (NMS) Securities; S&P 500- and Russell 1000- listed stocks, some exchange-traded products; Tier 2 Symbols priced below $3.00; price greater than $3.00 (price > $3.00) |
| 10% | 20% | Tier 2 NMS Securities (except for rights and warrants); other stocks priced over $3.00 (p > $3.00) |
| 20% | 40% | Other stocks priced greater than or equal to $0.75 and less than $3.00 ( $0.75 ≤ p ≤ $3.00) |
| Lesser than 75% or $0.15 | Lesser than 150% (upper limit only) or $0.30 | Other stocks priced less than $0.75 (p < $0.75) |
Circuit Breakers Brief History
Circuit breakers were introduced by regulators in response to major market crashes. Following the market crash on October 19, 1987, known as Black Monday, where the Dow Jones Industrial Average (DJIA) fell by approximately 22.6% in a single day, the first circuit breakers were implemented. These circuit breakers were designed to halt trading temporarily during extreme market volatility.
A notable incident that led to updates in the circuit breaker system occurred on May 6, 2010, known as the flash crash. During this event, the DJIA dropped nearly 1,000 points and quickly rebounded within minutes. Although prices mostly recovered by the market close, the effectiveness of the existing circuit breakers was questioned, prompting regulators to revise and improve the circuit breaker system.
A Well-Known Criticism of Circuit Breakers
Circuit breakers have been criticized by some analysts who argue that they disrupt the market and create artificial volatility. They claim that circuit breakers lead to a build-up of orders at the limit level and reduce liquidity. Critics of circuit breakers suggest that if the market were allowed to operate without interruptions, it would establish a more stable equilibrium.
Example of a Known Circuit Breaker
The circuit breaker halts occurred on multiple occasions in March 2020 at the New York Stock Exchange (NYSE). One of these instances was prompted by a significant market decline, with the S&P 500 falling by more than 7% at the market opening. This decline was likely influenced by the global impact of the coronavirus pandemic.
When Does a Market-Wide Circuit Breaker Trip?
Circuit breakers are used in markets to manage excessive volatility. When certain predefined thresholds are reached, trading across all markets is temporarily halted. These thresholds are typically based on the decline of a broad-based index, such as the S&P 500. The purpose of circuit breakers is to help stabilize the market during periods of extreme price movements.
Circuit Breaker Options Markets
When a circuit breaker is triggered in the equities market, trading in the corresponding listed options markets is also paused. Any trades executed after the halt are invalidated.
Do the Rules for Single-Stock Circuit Breakers Differ?
Under SEC rules, a trading pause is implemented for stocks when their price exceeds predefined thresholds within a specific time. The thresholds and duration vary based on factors such as the stock's price and its categorization, such as Tier 1, Tier 2, or other NMS-listed security.
Conclusion
Circuit breakers are temporary measures used in stock exchanges to prevent panic-selling and are triggered by significant drops in prices. The circuit breaker system has been revised over time based on past market crashes, with the first one introduced after the 1987 Black Monday. While some analysts criticize circuit breakers for disruptions in the market, others argue that they help stabilize the market during periods of extreme price movements.