What is a ‘circuit breaker’?

Man in suit stands facing a graph showing a line moving up and down

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For the fourth time in just 10 days the US investment market circuit breaker was triggered following a significant midday drop in the market.

Having only been triggered a handful of times since its inception just after the Black Monday crash of 1987, we’re treading on relatively uncertain territory where breakers are concerned.

This is such new territory that many investors may not have experienced, or even be aware of, what a circuit breaker actually is and the purpose it serves. So let’s find out.

What is it?

Market circuit breakers are a regulatory security measure set by the local financial regulator (in the US this is the SEC: Security and Exchange Commission) in order to temporarily halt trading in an attempt to curb panic selling.

These breakers don’t just exist in the US, but also in countries such as Japan, China and the Philippines.

In theory, halting trading like this gives spooked investors a chance to think and reevaluate their the situation, rather than continuing to snowball sell on impulse.

They also work to establish if there is enough liquidity in the markets to ensure sell orders can actually be fulfilled. However, its effectiveness is up for some debate.

Some background

Circuit breakers were first introduced as a regulatory measure as one of a number of reactions to Black Monday where markets such as the Dow Jones Industrial Average fell as much as 22% in just one day.

There are thought to have been many factors that contributed to this significant drop in 1987, that first originated in Hong Kong and then spread across the global markets, with one of those being a phenomenon called ‘Noise Trading‘.

Noise Trading could have whole theses dedicated to it – let alone a few lines within a post on some amateur-ass blog – but the basic principle states that these types of traders tend to make moves on impulse, or pseudo-information they believe to have some basis in truth, but in reality are more akin to picking the winner on a roulette table.

That’s why a circuit breakers plays a crucial role in, at least, attempting to re-establish rationality back into the market.

How does it work?

There are 3 different stages in which a circuit breaker will be activated (US specific):

Level 1 – Once the market drops 7% from the most recent closing price (the break at this stage lasts for 15 minutes).

Level 2 – Once the market drops 13% from the most recent closing price (this break also lasts for 15 minutes).

Level 3 – Once the market drops 20% from the most recent closing price (if this final breaker is triggered, trading is halted for the remainder of that trading day).

Levels 1 and 2 will not receive a 15 minute break if the drop happens after 3.25pm of that same trading day. However, trading for the day will always end if lever 3 is initiated.

Single equity breakers

These breakers are not just confined to whole indices. Sometimes a breaker can be activated on a particular stock if that stock price falls OR rises by a significant amount.

The percentage a stock needs to rise or fall before a the circuit breaker is activated, is also determined by the time of day and the price that individual share is worth (see image below):

Picture 1
Taken from Investopedia.com

This also includes ETFs despite them being a collection of single shares within a portfolio.

*

As mentioned briefly above, circuit breakers still divide opinion between some financial commentators. But the fact of the matter is they exist, and at no point in history have they been activated as much as in the last 10 days.

We are certainly experiencing unprecedented volatility that many individuals will never have lived through (myself included).

It’s important to remember that no one ever made money crystallising losses; don’t become a noise trader.

As hard as it is at the moment to see your portfolios drop so significantly, you have to remember your goals and why you were investing while the markets were soaring.

Anyone with a good number of years from their target date would be wise to take this in their stride and try to remain rational; it’s difficult but we’ll get there…eventually.

Stay safe out there.

 

 

 

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