What Is a Circuit Breaker in Trading? How Is It Triggered?

What Is a Circuit Breaker?

The term "circuit breaker refers" to an emergency-use regulatory measure that temporarily halts trading on an exchange. Circuit breakers attempt to curb in panic-selling and can also be triggered on the way up with manic-buying. They are commonly used for individual securities as well as broad market indexes like the S&P 500. Circuit breakers function automatically by stopping trading when prices hit predefined levels in exchanges around the world.

Key Takeaways

  • Circuit breakers are temporary measures that halt trading to curb panic-selling on stock exchanges.
  • U.S. regulations have three levels of a circuit breaker, which are set to halt trading when the S&P 500 Index drops 7%, 13%, and 20%.
  • Circuit breakers for individual securities are triggered whether prices move up or down.
  • The current system of circuit breakers has been revised several times based on feedback from past crises.
  • The first circuit breaker was put into place after the Dow Jones Industrial Average dropped nearly 23% on Oct. 19, 1987.

What's a Circuit Breaker?

How Circuit Breakers Work

A circuit breaker functions in the trading world the same way it does for electrical circuits in a home. When things get overloaded, it kicks in and shuts down the circuit. In trading, circuit breakers are emergency measures established by stock markets that shut down trading activity temporarily or for the rest of the trading day when market prices drop significantly. As noted above, this system applies to both individual securities and market indexes.

Since February 2013, there have been market-wide circuit breakers that respond to single-day declines in the S&P 500 index. When the index falls by 7% below its previous close, it is considered a Level 1 decline. A Level 2 decline refers to a drop of 13%. Finally, a Level 3 decline refers to a drop of 20%. These levels have not changed as of March 2022.

Level 1 or 2 circuit breakers halt trading on all exchanges for 15 minutes unless they are triggered at or after 3:25 PM (in which case trading is allowed to continue). Level 3 circuit breakers halt trading for the remainder of the trading day (from 9:30 a.m to 4:00 p.m.).

Unlike their market-wide counterparts, circuit breakers for individual securities are triggered whether the price moves up or down. Exchange-traded funds (ETFs) are treated as individual securities under the circuit breaker system, even though they represent portfolios of several securities.

Since all securities are halted when certain levels are triggered, they are known as market-wide circuit breakers.

Special Considerations

The table below outlines the acceptable trading ranges used to regulate individual securities within the current system of circuit breakers. If trading outside of these bands persists for 15 seconds, activity is halted for five minutes. The reference price is calculated using the average price over the previous five minutes but the maximum allowed pause is 10 minutes.

To accommodate the higher volumes generally associated with the opening and closing periods of the trading day, the bands are doubled for the last 25 minutes.

Since May 31, 2012, the Securities and Exchange Commission (SEC) has used a limit-up limit-down (LULD) mechanism to determine the thresholds for acceptable trading. In this framework, halts are triggered by up-or-down moves outside of certain bands, determined based on the security’s price and listing.

Key Parameters of the Circuit Breaker System
Acceptable up-or-down trading range (9:30 am-3:35 pm) Acceptable up-or-down trading range (3:35-4:00 pm) Security price, listing
5% 10% Tier 1 National Market System (NMS) Securities; S&P 500- and Russell 1000- listed stocks, some exchange-traded products; Tier 2 Symbols priced below $3.00; price greater than $3.00 (price > $3.00)
10% 20% Tier 2 NMS Securities (except for rights and warrants); other stocks priced over $3.00 (p > $3.00)
20% 40% Other stocks priced greater than or equal to $0.75 and less than $3.00 ( $0.75 ≤ p ≤ $3.00)
Lesser of 75% or $0.15 Lesser of 150% (upper limit only) or $0.30 Other stocks priced less than $0.75 (p < $0.75)
Circuit breakers are brought into effect if trading occurs outside of these predefined parameters.

Source: Limit Up Limit Down

History of Circuit Breakers

Regulators put the first circuit breakers into place following the market crash that occurred on Oct. 19, 1987. On this day, the Dow Jones Industrial Average (DJIA) shed 508 points–falling by approximately 22.6%–in a single day. The crash, which began in Hong Kong and soon impacted markets worldwide, came to be known as Black Monday.

A second incident, the so-called flash crash of May 6, 2010, saw the DJIA drop almost 1,000 points and rebounded minutes later. Prices mostly recovered by the market close, but the failure of the post-1987 circuit breakers to halt the crash caused the regulators to update the circuit breaker system at that time.

Criticism of Circuit Breakers

Some analysts believe that circuit breakers are disruptive and keep the market artificially volatile because they cause orders to build at the limit level and decrease liquidity. Critics of circuit breakers argue that if the market were allowed to move freely, without any halts, they would settle into a more consistent equilibrium.

Real-World Example of a Circuit Breaker

A recent example of circuit breaker activity occurred with rapid succession of four halts on March 9, March 12, March 16, and finally on March 18, 2020. On both of these days, circuit breakers were triggered at the New York Stock Exchange (NYSE). In one instance, the S&P 500 fell more than 7% at the open, likely in response to the severity of the growing global coronavirus pandemic.

When Is a Market-Wide Circuit Breaker Triggered?

Market-wide circuit breakers are triggered when the broad-based S&P 500 falls by a certain amount within a single trading day, which halts trading across all markets. It can be triggered at three circuit breaker thresholds relative to the prior day’s closing price of the S&P 500, The first is Level 1 at 7%, followed by Level 2 at 13%, and 20% at Level 3. The purpose of circuit breakers is to stem excess market volatility.

What Happens at Each Breaker Level Threshold?

If a Level 1 or Level 2 circuit breaker is triggered, trading halts for a minimum of 15 minutes. A Level 3 breach halts trading for the remainder of the trading day.

Are the Rules the Same for Single-Stock Circuit Breakers?

No, under SEC rules, a stock is required to undergo a trading pause if the stock price moves up or down outside the price band (5%, 10% or 20%) within a five-minute period. These rules vary depending on the price of the stock and whether it is a Tier 1, Tier 2, or other NMS listed security.

Are Options Markets Also Halted When a Circuit Breaker Is Triggered?

Yes, if the equities market triggers a circuit breaker, trading in the affected listed options markets is also halted. Any trades that occur after the halt are nullified.

Article Sources
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