What is a Circuit Breaker in Stock Market?

Explanation

  • Say a stock is trading at $ 500. Suppose all of a sudden, and 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 just five days. It may fall 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 derived by observing thefinancial statements of the companyFinancial Statements Of The CompanyFinancial statements are written reports prepared by a company’s management to present the company’s financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more, its growth perspective, its potential future revenue & many factors).The problem that arises is that the new investors see the company in a negative sense by ignoring the fundamentals of the company. In the long run (i.e., in years), the stock prices will fall if the fundamentals are weak. It should not happen.A similar story applies to the stock market as a whole. It helps 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 decide. So, they pause the trading game for a brief time.

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History

  • Historically, the US introduced the first market-wide circuit breaker in 1987 when the DJIA (Dow Jones Industrial Average) observed a massive decline of 22% in just one day. It was a significant 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 index’s previous day’s closing price is used to calculate 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 the 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. There are three levels of circuit breakers:

Level 1

It is the first breaker automatically placed by the exchange when the stock falls by a specified percentage from the last close price. At this point, the trading is halted for a few minutes & then it resumes.

Level 2

The second breaker is triggered when the stock price or the index again falls with a higher percentage (here, the percentage of the downfall is calculated concerning the closing price of the last day). At this point, the trading is halted for the same amount of time as in the level 1 breaker & then it is allowed to resume again.

Level 3

It is the third & final circuit breaker if the stock price or index continues to fall with a larger percentage than in the level 2 breaker. Here, the percentage of downfall is calculated concerning 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 a Level 1 or Level 2 circuit breaker is triggered before 3:25 pm, 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 a Level 3 circuit breaker gets triggered at any point in time during the said trading day, the market halts for the remainder of the trading day. So, you can see there is no upper limit for the 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 circuit breakers for individual securities with the same purpose to prevent excessive excess volatility in the trading of those stocks.Here, they are called bands, which get triggered depending upon percentage change concerning 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 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 around the globe caused today due to the Virus – Covid-19. The pandemic has caused the US markets to fall sharply.In the US, there is also the downfall of only global indices.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 2778. Trading was then halted for 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 a 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.

Conclusion

As per the discussion above, you can now understand the importance & purpose of circuit breakers. If no such breakers were 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 article has guided what Circuit Breaker is in the Stock Market and its meaning. Here we discuss how a circuit breaker works, its levels, and its effects. You can learn more about it from the following articles –

  • Stock Market BubbleHow does the Stock Market Work?What is Share Market?Share Trading Account