What is Circuit Breakers?

Key Takeaways

• Circuit breaker trading halts were introduced in 1988 to stabilize the stock market.

• Market-wide circuit-breakers are based on the S&P 500 Index. The thresholds are set at 7%, 13%, and 20% of the closing price for the previous day and are only applicable to price drops.

• Single stock circuit breakers follow the Limit Up-Limit Down Rule and can be triggered several times a day.

March 2020 saw a dramatic US stock market crash, with stock prices plunging continuously.

The S&P 500 triggered level 1 market-wide circuit breakers upon drops of over 7% on March 9, 12, 16, and 18. The market halted, and trade was suspended.

According to the US Securities and Exchange Commission, "The securities and futures exchanges have procedures for coordinated cross-market trading halts if a severe market price decline reaches levels that may exhaust market liquidity. These procedures, known as market-wide circuit breakers, may halt trading temporarily or, under extreme circumstances, close the markets before the normal close of the trading session."

Circuit breakers mainly include market-wide circuit breakers and limit-up-limit down circuit breakers (single stock circuit breakers).

According to the latest circuit breaker rules of the US stock markets, a 7%, 13%, and 20% drop in the benchmark S&P 500 Index marks level 1, 2, and 3 halts, respectively.

Background of circuit breaker rules

October 19, 1987, is a day known as "Black Monday". October 16, the Friday before Black Monday, saw a significant 5% decline in the Dow Jones Industrial Average, dragging world markets downward and spreading throughout Asia, Europe, and the US. The benchmark Hang Seng index was down over 10%, and European stocks followed suit. Then, the US stock market saw its Dow Jones Industrial Index shed value by 22%.

On October 20, the Hong Kong market announced a four-day market close. In October, the Sydney stock market fell 41%, the London stock market fell 26%, and the Toronto stock market fell 22%.

Since the stock market back then did not have the Limit Up-Limit Down Rule, a considerable number of investors' assets vanished.

In response to the stock market crash and to stabilize the market trend, in February 1988, the US Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) officially approved the circuit breaker plan submitted by the New York Stock Exchange and the Chicago Mercantile Exchange. The mechanism began implementation in October of that year.

The continued perfection of circuit breaker rules

Initially, the circuit breaker rules in the US markets were on a points-based system, not on percentages. It wasn't until January 1997 that there was an adjustment, where the trigger points were increased by 100 points respectively from the original one.

On October 27, 1997, the Dow plunged 7.18% to close at 7161.15 points, marking the largest drop since 1915 and the first time the circuit breakers were triggered. But the next day, the Dow rebounded sharply by 337.17 points, or 4.71%, to close at 7498.32 points.

For these two days of market trading, the SEC asked the Department of Market Regulation to conduct a retrospective study and find out "how does the circuit breaker mechanism affect stock price movements?"

On April 15, 1998, the revised circuit breaker mechanism was put into effect. The revision was mainly in two aspects: first, raising the threshold and establishing three trigger thresholds of 10%, 20%, and 30%; second, basing trigger points on the average closing value of the Dow for the previous month to establish trigger thresholds for the quarter.

On May 31, 2012, the NYSE made further revisions: first, the Dow Jones Industrial Average was replaced with the S&P 500 as the benchmark index for circuit breakers; second, the thresholds were modified to 7%, 13%, and 20%. The new mechanism has been implemented since February 4, 2013.

How do circuit breakers function?

According to the latest mechanism guidelines, market-wide circuit breakers work as follows:

Market decline refers to a drop in the S&P 500 Index during the regular trading session (9:30-16:00 EST) based on the previous day's closing price. If it were half-day trading, the closing time would be 13:00.

There are three circuit breaker thresholds: 7% (Level 1), 13% (Level 2), and 20% (Level 3). A market decline that triggers a Level 1 or Level 2 circuit breaker before 3:25 p.m will halt market-wide trading for 15 minutes, while a similar market decline "at or after" 3:25 p.m will not halt market-wide trading. If it were half-day trading, then the time would be 12:25.

Level 1&2 market-wide trading suspension can be triggered only once a day. For example, a fall of 7% triggers a Level 1 market halt, then the price rebounds and does not lead to trading suspension when it falls again to 7% unless the price fall triggers a Level 2 market halt.

If a Level 3 circuit breaker is triggered at any time during the trading day, there will be a market-wide trading halt for the remainder of the trading day.

Prior to 2020, only one market-wide market halt occurred in the US stock markets on October 27, 1997.

The other four occurred in March 2020 and were all Level 1 market halts.

Single stock circuit breaker

According to Investor.gov, the Limit Up-Limit Down circuit breaker ("LULD") was officially approved by the SEC in 2012. LULD is "a market volatility moderator designed to prevent large, sudden price moves in a stock" and applies to "all securities in the S&P 500, the Russell 1000 and select Exchange Traded Products". 

If the stock's price moves up or down by 10% or more within 5 minutes, it will undergo a trading pause. There will be a five-minute trading pause if the stock price does not naturally move back within the price bands within 15 seconds.

For S&P 500- and Russell 1000- listed stocks and some exchange-traded products with prices greater than $3, the acceptable fluctuation range is 5%. Other less liquid individual stocks with a trading price of $3 or less have a more flexible range of 10%.

If a stock triggers the circuit breaker and the time is:

Between 9:45 and 15:35 EST (inclusive), trading of the individual stock is suspended for 5 minutes.

After 15:35 EST, trading is not suspended. If it were half-day trading, then the time would be 12:25 EST.

Differences between market-wide circuit breakers and single stock circuit breakers

There are mainly five differences:

First, market-wide circuit breakers are index-based, and there is no limit on the increase of price; single stock circuit breakers are bound by the Limit Up-Limit Down Rule.

Second, the halt time of market-wide circuit breakers is within 35 minutes of the closing bell, while single stock circuit breakers are in effect between 15 minutes of the opening of the markets and 25 minutes before the close of the markets.

Third, market-wide circuit breakers lead to a 15-minute trading halt, while it is 5 minutes or longer for single stock circuit breakers.

Fourth, market-wide circuit breakers are based on the previous day's closing price, while single stock circuit breakers are triggered based on price movements in a 5-minute interval.

Fifth, market-wide circuit breakers can only be triggered once a day, while there is no limit to triggering single stock circuit breakers.

Take the stock price movement of GameStop (GME) on January 28, 2021, as an example. On that day, MEME stock speculation sent GME's share prices to the moon and back, triggering nearly 20 trading halts throughout the day under the circuit breaker mechanism.

With the help of the circuit breaker mechanism, the SEC can effectively control the abnormal rise and fall of the market and individual stocks, and therefore play a stabilizing role.