The circuit breaker mechanism is a regulatory tool designed to temporarily halt trading in financial markets during extreme price movements. It aims to prevent panic selling, reduce volatility, and maintain orderly market functioning. Circuit breakers are most commonly applied in stock markets but can also be used in other asset classes, such as commodities and futures.

Purpose of the Circuit Breaker Mechanism

1. Prevent Market Meltdowns:
   • Helps curb extreme sell-offs that could lead to market crashes.
2. Allow Cool-Off Periods:
   • Pauses trading temporarily to allow traders to reassess the situation and reduce panic.
3. Maintain Market Stability:
   • Reduces volatility and prevents irrational price movements.
4. Restore Investor Confidence:
   • Shows that regulators are actively monitoring and protecting market integrity.

How the Circuit Breaker Mechanism Works

Circuit breakers are triggered when a security, index, or market experiences significant price changes within a short period. These price thresholds are predefined and vary based on the asset and market regulations.

Types of Circuit Breakers

1. Market-Wide Circuit Breakers:
   • Triggered when an index (e.g., S&P 500) drops by a certain percentage.
   • Example: The NYSE implements a market-wide halt if the S&P 500 falls by 7%, 13%, or 20% in a single day.
2. Single-Stock Circuit Breakers:
   • Applied to individual stocks or securities when their price moves beyond a specific threshold.
   • Example: A stock might have a circuit breaker if it moves 10% above or below the previous close within 5 minutes.
3. Price Bands or Limits:
   • Sets upper and lower price limits for trading specific assets within a session.
   • Example: Futures markets often have daily price limits.

Typical Trading Halt Durations

• Level 1 Halt (Mild Drop): A brief pause, such as 15 minutes, to stabilise trading.
• Level 2 Halt (Moderate Drop): A longer pause, often 15-30 minutes, depending on market conditions.
• Level 3 Halt (Severe Drop): Trading may be suspended for the rest of the day.

Historical Example of Circuit Breakers in Action

• Black Monday (1987): The market crash of October 19, 1987, saw the Dow Jones Industrial Average drop by 22.6% in one day. This event prompted the introduction of circuit breakers to prevent such massive single-day declines.
• March 2020 (COVID-19 Pandemic): Circuit breakers were triggered multiple times as global markets plunged due to fears of the pandemic.

Advantages of the Circuit Breaker Mechanism

1. Reduces Panic Selling:
   • Provides time for traders to reassess decisions during volatile periods.
2. Prevents Flash Crashes:
   • Minimises the impact of algorithmic trading or errors that can lead to sudden price collapses.
3. Promotes Stability:
   • Maintains orderly market conditions and reduces extreme volatility.
4. Encourages Rational Decision-Making:
   • Gives investors a “cooling-off” period to analyse market conditions.
5. Protects Smaller Investors:
   • Reduces the risk of significant losses for retail traders during market turmoil.

Disadvantages of the Circuit Breaker Mechanism

1. Delays Price Discovery:
   • Pausing trading can disrupt the natural process of finding an equilibrium price.
2. Does Not Prevent Broader Market Issues:
   • Circuit breakers address short-term volatility but do not solve underlying market problems.
3. Creates Artificial Barriers:
   • May distort market behaviour by interrupting trades.
4. Possibility of Overreaction:
   • Traders may panic further when trading resumes, leading to continued sell-offs.
5. Algorithmic Trading Challenges:
   • Automated systems may struggle to adjust to halts, exacerbating volatility when trading resumes.

How Circuit Breakers Are Determined

Circuit breaker thresholds are based on:

1. Percentage Declines:
   • Typically set as a percentage drop from the previous day’s closing price or opening price.
2. Time-Based Limits:
   • Certain thresholds may vary depending on the time of day (e.g., broader limits in the morning).
3. Asset Class-Specific Rules:
   • Different rules apply to equities, futures, commodities, and other markets.
4. Exchange Regulations:
   • Each stock exchange has its own circuit breaker policies. For instance:
     • The New York Stock Exchange (NYSE) halts trading when the S&P 500 falls by 7%, 13%, or 20%.
     • The National Stock Exchange of India (NSE) imposes limits for 10%, 15%, or 20% declines.

How to Trade During Circuit Breakers

1. Stay Calm:
   • Avoid panic trading and reassess market conditions during the halt.
2. Plan in Advance:
   • Understand the circuit breaker rules of the market you trade in and adjust your strategy accordingly.
3. Monitor News and Events:
   • Stay updated on news that may cause significant price movements.
4. Manage Risk:
   • Use stop-loss orders and position sizing to protect against sudden market declines.
5. Avoid Over-Leveraging:
   • Leverage amplifies losses during volatile periods and circuit breaker events.

FAQs

What is the circuit breaker mechanism?
It is a regulatory tool used to pause trading during extreme price movements to reduce volatility and panic selling.

What triggers a circuit breaker?
A circuit breaker is triggered when a security or market index experiences a predefined percentage price drop within a specific period.

How long do trading halts last?
Halt durations vary but typically range from 15 minutes to the remainder of the trading day, depending on the severity of the price movement.

What is a single-stock circuit breaker?
It is a circuit breaker applied to an individual stock when its price moves beyond a specific percentage threshold.

Are circuit breakers used in forex trading?
Circuit breakers are uncommon in forex due to its decentralised nature but can be applied to forex futures traded on regulated exchanges.

Do circuit breakers prevent market crashes?
They do not prevent crashes but help slow them down, giving investors time to reassess.

What happens after a circuit breaker is triggered?
Trading resumes after the halt, often leading to either stabilisation or further volatility depending on market sentiment.

Do all markets use circuit breakers?
Not all markets have circuit breakers; their implementation depends on the exchange and regulatory body.

How do circuit breakers impact retail traders?
They protect retail traders from extreme volatility but may also limit their ability to react to fast-changing markets.

What are price limits in futures markets?
Price limits cap how much a futures contract can rise or fall in a single trading session.

Conclusion

The circuit breaker mechanism is a critical tool in maintaining market stability during extreme volatility. By pausing trading during sharp price movements, it helps protect investors, promote rational decision-making, and reduce panic selling. While it cannot prevent market downturns, understanding how circuit breakers work can help traders better navigate turbulent markets and manage risk effectively.