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 March 2020 as the escalating COVID-19 pandemic roiled markets worldwide.
What are circuit breakers and how do circuit breakers work? Those are just a couple of important questions for investors. Read up on a few basics.
What Is a Market-Wide Circuit Breaker?
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,” as NYSE noted on its website.
What’s the Function of a Market Circuit Breaker?
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.
“The primary function of circuit breakers is to slow momentum and let things ‘cool off’ for a moment,” said JJ Kinahan, chief market strategist at TD Ameritrade.
Investing and trading in essence are about relationships, Kinahan noted, which means that, occasionally, buying or selling momentum comes so fast and furious that the relationships between the indices and their individual components gets askew. “Circuit breakers help slow this momentum and get the relationships back in line, which allows stability in the market.”
What’s the History of Circuit Breakers in U.S. Markets?
U.S. stock exchanges established circuit breakers following the October 1987 crash. Although markets have seen many sharp declines and high-volatility periods since then, circuit breakers have rarely been used.
Before the 2020 selloff, 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 over 7%. Thus far in 2020, U.S. circuit breakers have halted trading on four days: March 9, 12, 16, and 18.
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, the U.S. Securities and Exchange Commission in 2012 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 of a specified price band based on the average price of the stock over the preceding five-minute trading period.
What Are the Three Levels of Market-Wide Circuit Breakers Used by U.S. Stock Exchanges?
Market-wide circuit breakers can be triggered at three thresholds measured against the previous trading day’s closing price of the SPX.
- The Level 1 circuit breaker kicks in once the SPX drops 7% from the prior day.
- A Level 2 circuit breaker is triggered with a 13% decline.
Level 1 and Level 2 circuit breakers can be triggered between 9:30 a.m. and 3:25 pm Eastern time, and in both cases, trading is halted for 15 minutes.
- A Level 3 circuit breaker is triggered by a 20% drop in the SPX, and trading is then halted for the rest of the trading day.
How Do the Exchanges Decide When to Resume Trading After a Circuit Breaker Is Triggered?
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,” the NYSE said on its website.
What About Stock Index Futures? Do They Have Circuit Breakers?
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. Eastern—same as above), CME Group’s index futures—including those based on the SPX, $DJI, and 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 virtually around the clock Sunday afternoon through Friday afternoon, with one 30-minute pause each evening) there are 5% up-and-down limits in place.
What Should Investors Do When Circuit Breakers Are Triggered?
You’re only human, but try to keep your wits, remain calm and composed, and don’t get swept into whipsawing markets. Kinahan 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 place smaller orders to account for these sorts of movements,” he said.
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, Kinahan added.
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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