What is a circuit breaker in the stock market? Stock market circuit breakers are temporary trading halts imposed by stock exchanges. Read up on a few basics.
Markets are fundamentally human and therefore fueled by human emotions, including anxiety and fear. When such emotions get excessive, market-wide circuit breakers can come into play. These mechanisms serve as a brief “time-out” for investors and traders to step back and get a grip.
Circuit breakers were triggered several times in U.S. equities in 2020 as the escalating COVID-19 pandemic roiled markets worldwide.
What are stock market circuit breakers, and how do circuit breakers work? Those are just a couple of important questions for investors. Read up on a few basics.
Circuit breakers are temporary trading halts imposed by stock exchanges, such as the Nasdaq® and New York Stock Exchange (NYSE), if a market benchmark, such as the S&P 500® index (SPX), declines by 7% or more. U.S. equity and options exchanges apply these coordinated cross-market halts “if a severe market price decline reaches levels that may exhaust market liquidity,” according to the NYSE website.
As electricians know, circuit breakers are a critical safety mechanism in any home or business that slashes the flow of power in the event of a “surge.” In the markets, circuit breakers serve a similar purpose, helping provide a brief respite during times of excess volatility or emotion-driven trading.
“Circuit breakers allow markets to cool off during periods of extraordinary volatility,” said Alex Coffey, Senior Trading Strategist at TD Ameritrade.
“These rare moments of tremendous volatility happen when there are lopsided supply-demand imbalances during the session, usually due to extraordinary events,” Coffey added. “Essentially, exchanges put the market in a ‘time out’ for a short while to allow trading relationships to normalize and overall market stability to return.”
U.S. stock exchanges established circuit breakers following the October 1987 crash, also known as Black Monday. Although markets have seen many sharp declines and high-volatility periods since then, circuit breakers have rarely been used.
Before the 2020 sell-off, U.S. market-wide circuit breakers had been used only once—in October 1997—as the Asian financial crisis sent the Dow Jones Industrial Average® ($DJI) down more than 7%. In 2020, the U.S. circuit breakers were halted for four days in March alone.
Over the years, exchanges and regulators have added other measures aimed at helping markets find their bearings during exceedingly choppy times, such as the May 2010 “flash crash,” when $DJI fell 9% in about 10 minutes, then quickly reversed course.
For example, in 2012, the U.S. Securities and Exchange Commission (SEC) approved a “limit up/limit down” mechanism to address market volatility by preventing trades in listed equity securities when triggered by large, sudden price moves in an individual stock. The mechanism is intended to prevent trades in individual securities from occurring outside a specified price band based on the stock’s average price over the preceding five-minute trading period.
Market-wide circuit breakers can be triggered at three thresholds measured against the previous trading day’s closing price of the SPX.
Level 1 and Level 2 circuit breakers can be triggered between 9:30 a.m. and 3:25 p.m. ET, and in both cases, trading is halted for 15 minutes.
The default length for Level 1 and Level 2 triggers is 15 minutes, although the exchanges reserve the right to alter the length depending on how chaotic the situation is and how much time the exchanges believe it will take to restore “orderly” markets and proper price discovery between buyers and sellers. The Nasdaq, NYSE, and other exchanges have established procedures and various criteria for when and how trading can resume following a circuit breaker.
At the NYSE, for example, designated market makers (DMMs) are responsible for facilitating the reopening auctions in NYSE-listed securities. DMMs can facilitate auctions electronically, at a designated reopening time, or manually, and an NYSE-listed security will not reopen “until all better-priced orders (including market orders) … can be satisfied in the reopening auction,” according to the NYSE website.
Futures markets have what are called price limits—daily up-and-down fluctuation limits. If the offer price is at the lower daily limit, the futures are “limit down.” If the futures are bid at the upper limit, they’re “limit up.” Trades are allowed to occur at the limit prices, but not beyond them.
During regular trading hours (9:30 a.m. to 3:25 p.m. ET—same as above), CME Group’s index futures—including those based on the SPX, $DJI, and Nasdaq-100® Index (NDX)—have limits that correspond to Level 1 (7%), Level 2 (13%), and Level 3 (20%) above.
Outside of regular trading hours, futures are traded nearly around the clock Sunday afternoon through Friday afternoon, with a one-hour maintenance pause each evening.
You’re only human, but try to keep your wits, remain calm and composed, and don’t get swept into whipsawing markets. Coffey pointed out that if circuit breakers kick in, market volatility has likely increased, and investors might see bigger—and perhaps faster—moves in the market. To combat this, investors “may want to consider using a smaller trade size until the market stabilizes,” Coffey added.
It’s also particularly important for investors to have a very clear view of the time frames for their investments—whether those time frames are measured in days, weeks, months, or years, according to Coffey.
There’s not much anyone can do until trading resumes, so consider using the circuit breaker as an opportunity to assess your portfolio and think about your long-term strategy.
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