A stock market circuit breaker is a mechanism designed to temporarily halt trading on an exchange in response to significant declines in stock prices within a short period. The purpose of circuit breakers is to provide a brief cooling-off period during times of extreme market volatility, allowing investors time to digest information, prevent panic selling, and maintain orderly market functioning. Explore how it works -:
1. Trigger Levels: Circuit breakers are typically triggered by predetermined percentage declines in a broad market index, such as the S&P 500 or the Dow Jones Industrial Average. These trigger levels are set by the exchange and are intended to reflect significant market movements.
2. Temporary Halts: When the trigger level is breached during a trading session, a circuit breaker is activated, and trading is halted for a predetermined period. The length of the halt depends on the severity of the decline and the rules established by the exchange. Common durations for trading halts include 15 minutes, 30 minutes, or the remainder of the trading day.
3. Calibration: Circuit breakers are often calibrated to have multiple trigger levels, each corresponding to different levels of decline. For example, there may be separate circuit breakers for a 7%, 13%, and 20% decline in the market index. The severity of the decline determines which circuit breaker is triggered and the duration of the trading halt.
4. Market-Wide vs. Individual Securities: Circuit breakers can apply either to the entire market (market-wide circuit breakers) or to individual securities (individual stock circuit breakers). Market-wide circuit breakers are triggered by declines in the overall market index, while individual stock circuit breakers are triggered by rapid declines in the price of specific stocks.
5. Resumption of Trading: After the temporary trading halt ends, trading resumes according to normal market procedures. However, if the market continues to decline after trading resumes, additional circuit breakers may be triggered, leading to further trading halts.
6. Purpose and Impact: Circuit breakers are designed to prevent excessive volatility and promote market stability during times of stress. By temporarily halting trading, circuit breakers give investors time to reassess their positions, reduce panic selling, and prevent disorderly market conditions. However, critics argue that circuit breakers can sometimes exacerbate market volatility by creating uncertainty and causing liquidity to dry up.
Circuit breakers serve as a risk management tool for exchanges, helping to maintain orderly trading and protect investors from extreme market movements. However, their effectiveness depends on various factors, including the design of the circuit breaker mechanism and the underlying causes of market volatility.
