Circuit Breaker
A regulatory instrument that halts the trading of a security or an index for a certain period
What is a Circuit Breaker?
A circuit breaker is a regulatory instrument that halts the trading of a security or an index for a certain period. Circuit breakers are triggered when a security experiences a large percentage swing in either direction or a market index experiences a catastrophic decline. Circuit breakers are used to prevent excessive speculative gains or losses on a security or devastating losses in the markets.
The trading halt caused by circuit breakers provide the necessary break to market participants to incorporate and analyze all the latest events and news to make a rational trading decision.
Circuit Breakers in the U.S.
The first market-wide circuit breakers were introduced in the U.S. after Black Monday in 1987 when the Dow Jones Industrial Average (DJIA) declined by 22% in one day.
However, the rules established after Black Monday did not help to prevent the Flash Crash in 2010. In February 2013, the U.S. Securities and Exchange Commission (SEC) introduced new market-wide circuit breakers rules. The S&P 500 index was chosen as the new benchmark, replacing the Dow. The percentage decline of the market index is calculated on the prior-day closing price of the S&P 500.
The market index percentage changes were split into three tiers. Level 1 tier sets up a threshold of 7% decline, level 2 circuit breaker triggers a 13% decline, and level 3 sets up a benchmark of 20% slump. Level 1 and 2 halt the trading for 15 minutes if a market drop occurs before 3:25 p.m. However, if the decline occurred at or after 3:25 p.m., the trading continues. Level 3 circuit breaker stops the trading for the remainder of the trading day in any circumstances.
In addition to market-wide circuit breakers, in 2012, the SEC introduced the Limit Up-Limit Down mechanism to prevent the excessive volatility in the trading of a single security. The Limit Up-Limit Down system establishes the bands of the price changes of a security relative to the security’s average price for the last five-minute period.
The limit bands are 5%, 10%, and 20%. Moreover, the limits are doubled in the beginning and closing of the trading day. The circuit breakers are triggered if a stock price change exceeds the given limits and does not rebound within 15 seconds. In such a case, a security is stopped trading for five minutes.
In addition to market-wide circuit breakers, in 2012, the SEC introduced the Limit Up-Limit Down mechanism to prevent the excessive volatility in the trading of a single security. The Limit Up-Limit Down system establishes the bands of the price changes of a security relative to the security’s average price for the last five-minute period.
The limit bands are 5%, 10%, and 20%. Moreover, the limits are doubled in the beginning and closing of the trading day. The circuit breakers are triggered if a stock price change exceeds the given limits and does not rebound within 15 seconds. In such a case, a security is stopped trading for five minutes.
Additional Resources
CFI is the official provider of the Financial Modeling & Valuation Analyst designation for financial analysts. To continue learning and advancing your career, these additional resources will be helpful: