Definition
A Circuit Breaker in the Stock Market is a safeguard mechanism that temporarily halts trading on an exchange to curb excessive volatility or drastic market declines. It’s triggered when there are significant movements (either up or down) in market indices within a specific time period. Its purpose is to allow investors time to assess information and make thoughtful decisions during periods of high market volatility.
Key Takeaways
- A Circuit Breaker in stock market is a regulatory measure to temporarily halt trading on an exchange. This is implemented when extreme price changes in a security occurs, to prevent potential market crashes.
- These mechanisms get triggered by sharp falls or rises within predefined thresholds, typically measured in terms of the market index movement. They are typically set at 7%, 13%, and 20% of the closing price for the previous day.
- Circuit Breakers provide safeguards against market volatility and offer a cooling-off period for investors to make informed decisions. However, they could also delay the price discovery process and cause disruption in market continuity.
Importance
Circuit breakers in the stock market are essential for maintaining stable and orderly financial markets during periods of significant price changes.
They act as safety mechanisms (like a “break” in an electrical circuit) that halt trading when stock prices hit critical levels within a trading day, aiming to curb panic-selling and prevent a market crash.
By providing a pause or “cooling off” period during extreme volatility, they give investors time to assess information and make decisions based on rational judgment rather than fear or speculation.
Effectively, circuit breakers contribute to investor confidence and market integrity.
Explanation
The purpose of a circuit breaker in the stock market is primarily to prevent excessively volatile trading, which can lead to drastic market downturns and panic-selling. This built-in safety mechanism temporarily halts trading on an exchange if there are significant swings in either direction.
It’s essentially a protective measure that interrupts trading to allow the market participants to absorb information calmly, adjust their positions accordingly and prevent a dangerous domino effect caused by widespread panic trading. Circuit breakers are also used to safeguard the overall health and integrity of the equity markets.
By preventing sharp, sudden market falls, they act as buffers against potential economic shocks that could trigger broader financial instability. They offer an opportunity for investors to understand the reasons behind the dramatic market movement, reassess their investment strategies and make informed decisions rather than reacting impulsively to abrupt market shifts.
Examples of Circuit Breaker in Stock Market
The Black Monday of 1987: One of the most well-known examples of circuit breakers in action is the Black Monday stock market crash of
After the Dow Jones Industrial Average fell by 22% in a single day, the SEC introduced circuit breakers to prevent such rapid and dramatic drops in the future.
The Stock Market Fall of 2020: During the onset of the Covid-19 pandemic in March 2020, circuit breakers were frequently triggered as stocks plummeted worldwide in response to the global health emergency. Trading was halted multiple times within the month to allow investors to process new information and decrease panic.
2016 Shanghai Stock Market Crash: The Chinese stock market experienced an early-year slump in 2016, resulting in the activation of circuit breakers twice within the same week. This moment is memorable because it showed the downside of circuit breakers, as their activation spurred further panic selling once the markets reopened, causing the Chinese government to suspend the mechanism shortly after.
Frequently Asked Questions about Circuit Breaker in Stock Market
What is Circuit Breaker in Stock Market?
A circuit breaker in the stock market is a regulatory measure to temporarily halt trading on an exchange. It is triggered when there are significant downswings in the market to prevent panic-selling.
How does a Circuit Breaker work?
Circuit breakers work by temporarily stopping trade when a market index experiences a high percentage drop within a short period. The halt in trading gives the market time to calm and prevents a more severe market crash.
What are the levels of Circuit Breaker in Stock Market?
There are usually three circuit breaker levels—7%, 13%, and 20%, which correspond to the drops in the S&P 500 index. Level 1 and Level 2 halts trading for 15 minutes, while Level 3 stops trading for the rest of the day.
Who sets the Circuit Breaker rules?
The Securities and Exchange Commission (SEC) sets the circuit breaker rules for all exchanges and FINRA. They were introduced after the stock market crash in 1987 to prevent a recurrence.
Can Circuit Breaker halt trading for the whole day?
Yes. If the drop in the S&P 500 index is 20% or more, Level 3 circuit breaker kicks in; it halts trading for the rest of the trading day.
Related Entrepreneurship Terms
- Trading Halts
- Price Bands
- Market Volatility
- Securities and Exchange Commission (SEC)
- Financial Stability
Sources for More Information
- Investopedia: A comprehensive online resource dedicated to investing and personal finance.
- CNBC: A recognized world leader in business news, providing real-time financial market coverage and business content.
- Bloomberg: A global information and technology company that delivers business and financial news, data, analysis, and more.
- Reuters: An international news organization, is a leading provider of news and information about investing, finance, and business.
