A circuit breaker refers to a set of predefined rules and mechanisms designed to temporarily halt or suspend trading in the event of significant market volatility or a rapid decline in prices. The purpose of circuit breakers is to provide a cooling-off period, prevent panic selling, and allow market participants to reassess their positions.
Circuit breakers are triggered based on specific thresholds, usually percentage declines in a market index, such as the S&P 500. When triggered, trading is halted for a predetermined period, allowing investors to digest information and potentially avoid further panic-driven selling.
There are typically three levels of circuit breakers -
1. Level 1 (L1): This is a minor threshold, usually a small percentage decline in the market index, which triggers a brief pause in trading.
2. Level 2 (L2): If the decline continues beyond the Level 1 threshold, a more significant pause in trading is implemented to give investors additional time to assess the situation.
3. Level 3 (L3): If the decline persists beyond the Level 2 threshold, trading is halted for the rest of the trading day. This level is intended to prevent extreme market conditions and give authorities time to address any underlying issues.
Circuit breakers are implemented to maintain market stability and prevent a cascading effect of panic selling. They were introduced after major market crashes, such as the 1987 Black Monday crash, to mitigate the impact of extreme volatility. The specific rules and thresholds for circuit breakers may vary between stock exchanges and can be updated periodically to adapt to changing market conditions.
