Circuit Breaker

What is a Circuit Breaker?

A circuit breaker is a regulatory instrument that halts the trading of a securityStockWhat is a stock? An individual who owns stock in a company is called a shareholder and is eligible to claim part of the company’s residual assets and earnings (should the company ever be dissolved). The terms "stock", "shares", and "equity" are used interchangeably. 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 declineThe Great DepressionThe Great Depression was a worldwide economic depression that took place from the late 1920s to the early 1930s. For decades debates have been going on abou. Circuit breakers are used to prevent excessive speculative gains or losses on a security or devastating losses in the markets.

The tradingTrading & InvestingA 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 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)Dow Jones Industrial Average (DJIA)The Dow Jones Industrial Average (DJIA), also commonly referred to as "the Dow Jones” or simply "the Dow", is one of the most popular and widely-recognized stock market indices 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 volatilityVIXThe Chicago Board Options Exchange (CBOE) created the VIX (CBOE Volatility Index) to measure the 30-day expected volatility of the US stock market, 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 volatilityVIXThe Chicago Board Options Exchange (CBOE) created the VIX (CBOE Volatility Index) to measure the 30-day expected volatility of the US stock market, 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 AnalystFMVA™ CertificationThe Financial Modeling & Valueation Analyst (FMVA)™ accreditation is a global standard for financial analysts that covers finance, accounting, financial modeling, valuation, budgeting, forecasting, presentations, and strategy.  designation for financial analysts. To continue learning and advancing your career, these additional resources will be helpful:

• Daily Trading LimitDaily Trading LimitThe daily trading limit refers to the maximum amount by which the price of a stock or other exchange-traded security can rise or fall during a trading session. The limits are decided by the exchange in an attempt to avoid extreme volatility or manipulation in the markets.
• Proprietary TradingProprietary TradingProprietary Trading (Prop Trading) occurs when a bank or firm trades stocks, derivatives, bonds, commodities or other financial instruments in its own account, using its own money instead of using its clients’ money. It allows a firm to earn full profits from a trade rather than just the commission it receives
• Stock HaltStock HaltA stock halt, often referred to as a trading halt, is a temporary halt in the trading of a security. Usually, a stock halt is imposed for regulatory reasons
• Trading MechanismsTrading Mechanisms - TradingTrading mechanisms refer to the different methods by which assets are traded. The two main types of trading mechanisms are quote driven and order driven trading mechanisms