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 provides the necessary break for market participants to incorporate and analyze the latest events and make rational trading decisions.
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 based on the previous day’s 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 at a 13% decline, and level 3 sets up a benchmark of a 20% slump. Levels 1 and 2 halt the trading for 15 minutes if a market drop occurs before 3:25 p.m. However, if the decline occurs at or after 3:25 p.m., the trading continues. Level 3 stops the trading for the remainder of the trading day in any circumstances.
Limit Up and Down Breaks
In addition to market-wide circuit breakers, in 2012, the SEC introduced the Limit Up-Limit Down mechanism to prevent excessive volatility in the trading of a single security. The Limit Up-Limit Down system establishes 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 at 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, the security stops trading for five minutes.
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