What is Circuit Breaker in Stock Market?
Circuit breaker in stock market (also called as a market curb) is nothing but a break (i.e. a temporary slowdown) in the circuit (i.e. trading in the market), which is used to prevent panic-selling of stocks within a very short span of time (say within minutes or hours) and stops the trading for a specified period of time so that accurate information flows over the market within that time-frame, thereby preventing speculative gains & irrational losses.
- Say a stock is trading at $ 500. Suppose all of a sudden all the investors start selling their invested stocks. What will happen to the stock price? It will eventually fall by the law of demand say $ 65 in a span of just 5 days. It may happen that it falls at such a low that the price does not even reflect its fundamental value (i.e. the minimum should be the price of the stock which is derived by observing the financial statements of the company, its growth perspective, its probable future revenue & many factors).
- The problem arises is that the new investors see the company in a negative sense by ignoring the fundamentals of the company. This should not happen. In the long run (i.e. in years), the stock prices will eventually fall if the fundamentals are really weak.
- A similar story applies to the stock market as a whole. They help curb the irrational panic selling of the investors. It allows the investor to take a break – think about the stock whether it is the right time to trade – and then make a decision. So, they pause the trading game for a temporary time.
- Historically, the US introduced the first market-wide circuit breaker in the year 1987 when the DJIA (Dow Jones Industrial Average) observed a massive decline of 22% in just one day. This was a big loss.
- Later in February 2013, new rules for market-wide circuit breakers were introduced by SEC (Securities & Exchange Commission) & the S&P 500 Index was chosen as a new benchmark for circuit breakers. Thus, the prior day closing price of the index is used for calculating the percentage decline.
- It prevents the downside, there is also a concept of “Circuit filters” which prevent an unreasonable upsurge in the stock prices due to “panic-buying”. Time being, let`s only focus on circuit breakers.
How Does Circuit Breaker in Stock Market Work?
The basic intention of circuit breakers is to pause the panic-selling button. They apply to both individual stocks as well as market indices. Basically, there are three levels of circuit breakers:
This is the first breaker automatically placed by the exchange when the stock fall by a specified percentage from the last close price. At this point in time, the trading is halted for a few minutes & then it resumes.
This is the second breaker which is triggered when the stock price or the index again falls with a higher percentage (here the percentage of the downfall is calculated with reference to the closing price of last day). At this point in time, the trading is halted for the same amount of time as in level 1 breaker & then it is allowed to resume again.
This is the third & final circuit breaker if the stock price or index continues to fall with a larger percentage than in level 2 breaker. Here, the percentage of downfall is calculated with reference to the closing price or value at which the last day was closed. If level 3 of the circuit is placed, there is no resuming back – the trading is stopped for the remainder of the day. It opens directly on the next market day.
If Level 1 or Level 2 circuit breaker is triggered before 3:25 pm, only then the market halts trading for 15 minutes. However, if circuit breakers get triggered after 3:25 pm, there is no halt in the market trading. On the other hand, if Level 3 circuit breaker gets triggered at any point in time during the said trading day, the market halts for balance remainder of the trading day. So, you can see there is no upper limit for level 3 circuit breaker.
Circuit Breaker in Stock Market Levels
The circuit breakers are placed one by one. The levels are as follows:
Circuit Breaker Limit Up & Down
- The SEC also introduced the circuit breakers for individual securities with the same purpose to prevent the unreasonable excess volatility in the trading of those stocks.
- Here, they are called bands, which gets triggered depending upon percentage change with respect to the average price for the last 5-minute period of trading.
- The band-limits are as follows:
- The bands get triggered if the price of the security changes above the limits & does not restore in the limit within 15 seconds of the triggering event. The trading is halted for 5 minutes.
Circuit Breaker Halt
The trading halt means a pause in the trading as specified by the exchange regulator. So, SEC has specified the trading halts as follows:
Impact of Circuit Breaker on Stock Market
- You should be aware of the situation of the globe caused today due to the Virus – Covid-19. The pandemic has caused the US markets to fall down sharply.
- Not only the US, but there is also downfall only global indices as well.
- The circuit breaker was placed on March 9, 2020 when the S&P Index fell from 2971 to 2778 within a few seconds of the opening of the index. The US Stock market has fallen by 193 points after it touched the level of 2778. Trading was then halted by 15 minutes. There was no level 2 or level 3 circuit on that day.
- Again, on March 12, 2020, the S&P 500 Index witnessed the circuit breaker. The market observed level 1 circuit breaker when the index fell from 2738 to 2516. The trading was halted for 15 minutes. There was no level 2 or level 3 circuit on that day.
As per the discussion above, you can now understand the importance & purpose of circuit breakers. If there were no such breakers in place, the market would have erased all the upsurges to date only due to temporary outages or temporary information. It controls the market to that extent so that investors are given time to rethink & avoid panic-decision making.
This has been a guide to What is Circuit Breaker in Stock Market and its meaning. Here we discuss how does circuit breaker works, with its levels, and effects. You can learn more about from the following articles –