A temporary trading halt in an effort to reduce market volatility and massive panic sell-offs
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A trading curb is a temporary trading halt imposed in an effort to reduce market volatility and massive panic sell-offs. It is also called a circuit breaker and is instituted to reduce market volatility and information asymmetry by giving traders enough time to respond with full information. Amid extreme market swings, a trading curb is imposed as a market intervention during a normal trading process in the hope of stabilizing prices and restoring the market to normalcy.
A trading curb is a measure used to temporarily halt trade to stabilize the stock market in the face of large price movements to reduce excess market volatility.
A trading curb is instituted to curb the potential negative impacts of intraday trading turmoil on market stability.
There are three levels on the U.S stock exchanges that would induce trading curbs: Level 1 break, Level 2 break, and Level 3 break.
Early History of Trading Curbs
A trading curb is a regulatory requirement to shut the market down under Rule 80B of the Securities and Exchange Commission (SEC). It is aimed at reducing market volatility by imposing a temporary halt on trading on a specific security.
The first trading curb was implemented in the U.S. following the Black Monday of 1987, when the stock market, alongside associated futures and options markets, crashed. It was a market-wide circuit breaker advocated by the Brady Commission after the S&P 500 stock market dropped by approximately 20% and was subsequently implemented in 1988.
The trading curb initiated in 1987 assumed that program trading was the reason behind the crash exacerbated by the difficulty in gathering information in a rapidly changing and chaotic environment. The 2010 Flash Crash marked the subsequent amendment of the rule in response to the market turbulence.
Activation of Trading Curbs
The activation of a trading curb attempts to prevent excessive intraday price fluctuation by allowing the market to catch its breath during an unusually turbulent day. Temporary trading halts give traders more time to gather and evaluate more information to make rational decisions and synchronize trading better when the curbs are lifted.
On U.S. exchanges, a trading curb applies to all equities, options, and futures and is applied in accordance with the breakpoints. Breakpoints are calculated daily, with the S&P 500 Index serving as the reference index.
Typically, there are three breaking points that would cause trading to be suspended, namely Level 1, Level 2, and Level 3. The breaking points are outlined below:
Level 1: Lower circuit level is triggered if the previous day’s S&P 500 Index closed with a decline of 7%. If a stock market crash is determined to be Level 1, trading is halted for 15 minutes, but the halt will not be imposed if the 7% decline occurs within 35 minutes of market close.
Level 2: Level 2 circuit is initiated if the previous day’s S&P 500 Index closed with a 13% decline in which the market is disrupted for 15 minutes. However, no trading is halted if the decline occurs within 35 minutes of closing trade.
Level 3: The upper circuit is imposed if the previous day’s S&P 500 Index closed with a 20% drop in which the market is shut down for the remainder of the day.
According to the current SEC rules, a security that is a member of either of QQ ETF, S&P 500 Index, or Russell 1000 Index attracts a trading halt if its value changes by 10% within five minutes.
Alternatively, a trading halt can be triggered if a security whose market price is equal to or greater than $1 per share experiences a 30% value change. A security whose price is less than $1 per share can also trigger a trading halt if its value changes by 50% within a five-minute time frame.
Classification of Trading Curbs
There are three types of circuit breakers, with each circuit breaker addressing different design capability situations, as explained below:
1. Order-imbalance circuit breakers
The order-imbalance circuit breakers are instituted on individual stocks at the request of a specialist. The specialist orders trade to be suspended on an individual stock in the face of an order imbalance. The temporary halt allows the specialist to gather enough information and establish a market-clearing price.
2. Volume-induced circuit breakers
The level of trading volume determines the cost-effectiveness of order processing. Breakeven costs are usually not met at low trading levels. Revenues generated from trading must be used to cover the fixed costs of operations, as recognized in the determination of trading exchange hours.
Scheduled closings are based on the idea that additions of operation costs will not be compensated adequately. Daily closes can be construed as the initiation of a trading curb.
3. Price-limit circuit breakers
Historically, the objective of circuit breakers policies is to keep volatility in check. Price limits in futures markets restrict trading within the upper and lower horizontal lines of the previous day’s closing. However, in the recent past, stock index contracts’ price limits have been set at market-closing rules to control price swings in futures contracts and cash markets.
The rule is evident when short trades are not offered on up-limit days, and the same is true for long trades on down-limit days. In the past, the rules on future exchanges incorporated the price limits into trading rules in response to threatened regulations. Such patterns suggest that without regulatory interventions, the price-induced trading curbs would not exist.
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