Circuit Breakers

Circuit breakers are a kind of safeguard put in place that is used to temporarily halt trading on an exchange.

This mechanism is designed to curtail panic-selling, which can open up sizable consequences for markets and investors.

Circuit breakers were seen as a needed addition to market trading, namely after the Flash Crash, which saw markets plunge in minutes.

By and large, circuit-breakers are protectionary means put in place to represent the thresholds at which stock market trading is halted market-wide.

These are adopted for US exchanges, namely for the S&P 500 Index.

How Do Circuit Breakers Work?

In the example of the S&P 500 index, circuit breakers will halt all trading on the United States Stock markets during dramatic drops that are set at 7%, 13%, and 20% of the closing price for the previous day. The circuit breakers are calculated daily.

This occurred multiple times in 2020 due to panic early on during the Covid-19 pandemic, which saw sizable declines that roiled equity markets.

In the event of a 7% drop, a Level 1 halt will take effect, whereby stopping trading for a period of 15 minutes if drop occurs before 3:25 p.m. Eastern Standard Time (EST).

At or after 3:25 p.m. EST, trading would continue, unless there is a Level 3 halt.

In the event of a level 13% drop, a Level 2 halt is initiated. In this case, trading will halt for 15 minutes if the drop occurs before 3:25 p.m. EST. At or after 3:25 p.m. EST trading will continue, unless there is a Level 3 halt.

The most extreme situation is in the case of a drop of 20% in which a Level 3 halt is triggered. If a Level 3 halt occurs at any time during the trading day, trading shall halt for the remainder of the day.

US regulatory authorities have also taken additional steps to address single stock price bands. The US Securities and Exchange Commission (SEC) implemented a new marketplace rule, known as the Limit Up-Limit Down Rule.

This measure is designed to prevent trades from executing outside of price bands established throughout the day for individual stocks and exchange-traded funds (ETFs).