What is Circuit Breaker
Circuit breakers are measures approved by the SEC to curb panic-selling on U.S. stock exchanges and excessive volatility—large price swings in either direction—in individual securities. Also known as "collars," circuit breakers temporarily halt trading on an exchange or in individual securities when prices hit pre-defined tripwires, such as a 13 percent intraday drop for the S&P 500, or a 15 percent rise in a company's share price over five minutes.
Breaking Down Circuit Breakers
Regulators put the first circuit breakers in place following the market crash of October 19, 1987, when the Dow Jones Industrial Average (DJIA) shed 508 points, or 22.6 percent, in one day. The crash, which began in Hong Kong, affected markets all over the world and has come to be known as Black Monday.
A second incident, the flash crash of May 6, 2010, saw the DJIA lose 998.5 points, or over 9%, in just ten minutes. Prices recovered—or very nearly—before market close, but the failure of post-1987 circuit breakers to halt a fat-finger trade and the panic it caused led FINRA, the exchanges and the SEC to develop a new market-soothing regime. (The "fat-finger trade" theory, which posited that an inattentive trader had typed too many zeros and thus placed a gargantuan sell order, later proved false. London-based trader Navinder Singh Sarao is thought to have caused the crash through the use of spoofing algorithms, but his alleged role was not revealed until his arrest in April 2015, after the current circuit breakers were put in place.)
Market-Wide circuit breakers
In effect since February 2013, market-wide circuit breakers respond to single-day declines in the S&P 500 Index: if the index falls to 7% below its previous close, this is known as Level 1; Level 2 is a 13% drop; Level 3 a 20% drop. Level 1 or 2 will halt trading on all exchanges for 15 minutes unless it occurs at or after 3:25 pm, in which case trading is allowed to continue. Level 3, whenever it happens, will halt trading for the remainder of the trading day (9:30 am to 4:00 pm). Before these rules were in place, the DJIA was the benchmark, and the thresholds were 10% (Level 1), 20% (2) and 30% (3).
Single-Stock Circuit Breakers
Unlike their market-wide counterparts, single-stock curbs go into effect whether the price moves up or down. Also note that other exchange-traded products, such as ETFs, fall under the "single-stock" umbrella, making the commonly used name for the rule slightly misleading. Since October 2013, the SEC has used a "limit-up limit-down" mechanism to determine the thresholds for acceptable trading. Halts are triggered by up-or-down moves outside of certain bands, determined based on the security's price and listing:
If trading outside of these bands persists for 15 seconds, trading is halted for five minutes. The reference price is calculated using the average price over the previous 5 minutes. The maximum allowed pause is 10 minutes, and the bands are doubled during the opening (9:30-9:45 am) and closing (3:35-4:00 pm) periods of the trading day.
Black Monday Redux
On August 24, 2015, global markets swooned again, leading China's state media outlet Xinhua to declare another "Black Monday." Trading in individual U.S. stocks and ETFs paused more than 1,200 times, but the circuit breakers that were supposed to safeguard market stability arguably backfired. Some ETFs tracking major indices, such as the iShares Core S&P 500 ETF, could not obtain pricing information because of the trading halts and fell far below the indices they tracked. The S&P 500 hit an intraday low 5.00 percent below its open, but the iShares Core S&P 500 ETF fell 21.91 percent below its open before recovering. Credit Suisse estimates that, on that date, 42 percent of trading volume was in ETFs, so their vulnerability to curb-induced departures from fair value could pose a danger in the future. The SEC's commissioner has said the regulator would look into modifying the rules to account for this situation.