Circuit Breaker
What is Circuit Breaker?
A circuit breaker in the financial markets is a regulatory mechanism designed to temporarily halt trading on an exchange when prices experience extreme fluctuations. This tool is implemented to prevent panic-selling and excessive volatility, allowing market participants time to assess information and make informed decisions.
Purpose
Circuit breakers aim to stabilize the market by curbing drastic price movements that may arise from emotional trading or unexpected news. They serve as a safeguard against market crashes and help maintain orderly trading.
Types of Circuit Breakers
1. Individual Security Circuit Breakers: These are triggered when the price of a specific stock hits predetermined upper or lower limits, halting trading for that particular security.
2. Market-Wide Circuit Breakers: These apply to broad market indices (like the S&P 500) and are triggered by significant percentage declines in the index, resulting in a temporary halt to all trading.
Circuit Breaker Threshold Levels
Different exchanges set specific thresholds for triggering circuit breakers. For example, in the Indian, circuit breakers are activated at:
Level 1: 5% decline
Level 2: 10% decline
Level 3: 20% decline
Each level corresponds to a different duration for the trading halt, with Level 3 halting trading for the remainder of the day.
Circuit Breaker: Operational Mechanism
When a circuit breaker is triggered, trading is paused for a set period (e.g., 15 minutes), allowing investors to reassess their positions based on new information. After this pause, trading resumes unless further thresholds are breached.
Historical Context - Circuit Breaker
The concept of circuit breakers was introduced following significant market events, such as the stock market crash on October 19, 1987 (known as Black Monday), when the Dow Jones Industrial Average fell by nearly 23% in one day. This led to the establishment of rules aimed at preventing similar occurrences in the future.
Advantages and Criticisms
Advantages:
- Market Stability: Circuit breakers help prevent extreme volatility and provide time for investors to digest information.
- Reduced Panic Selling: By halting trading during rapid declines, they mitigate fear-driven sell-offs.
Criticisms:
- Liquidity Issues: Critics argue that circuit breakers can decrease liquidity by preventing real-time price adjustments and creating order backlogs.
- Artificial Volatility: Some analysts believe that halting trading can lead to more significant price swings once trading resumes, rather than settling into a stable equilibrium.
