What is a circuit breaker in the stock market?

A **circuit breaker** in the stock market refers to a mechanism used to temporarily halt trading in order to prevent panic selling or buying during extreme market conditions. It is designed to protect investors and maintain orderly market behavior by giving them time to digest information and make informed decisions. Circuit breakers are typically triggered when there is a sharp and sudden movement in the market, either upwards or downwards. In this blog, we will dive deep into what circuit breakers are, how they work, and why they are important for the stability of financial markets.

1. What is a Circuit Breaker?

A **circuit breaker** is a regulatory measure implemented by stock exchanges to prevent extreme market volatility. When prices move beyond a predefined threshold (usually a percentage change), trading is temporarily halted. The objective is to prevent panic and ensure that investors have time to assess the situation before making further decisions. Circuit breakers apply to both individual stocks and entire markets.

For example, if the market declines by a certain percentage, such as 7% in a single trading day, the exchange may halt trading for a brief period to allow investors to absorb the information and decide on their next move. This can help reduce the possibility of a market crash triggered by emotions or herd behavior.

2. How Do Circuit Breakers Work?

Circuit breakers are triggered when there is a significant price movement in the stock market or in individual stocks. These movements could be due to a variety of factors such as economic news, geopolitical events, or unexpected market behavior. Circuit breakers operate on the following rules:

• Thresholds for Market-wide Circuit Breakers: Typically, a market-wide circuit breaker is triggered when major stock indices like the **S&P 500** decline by a specific percentage. In the U.S., these thresholds are generally:
• **Level 1**: 7% decline, trading is halted for 15 minutes.
• **Level 2**: 13% decline, another 15-minute halt is triggered.
• **Level 3**: 20% decline, trading is halted for the remainder of the day.
• Individual Stock Circuit Breakers: If a single stock experiences a dramatic price drop (often 10-20% or more), a circuit breaker can halt trading in that stock alone. This prevents individual stocks from being subjected to excessive volatility.

The goal of circuit breakers is to prevent sharp, unpredictable declines or surges in prices that can create a "snowball effect" of panic selling or buying. By halting trading for a brief period, circuit breakers provide a chance for the market to stabilize, investors to process information, and market participants to make reasoned decisions.

3. Why Are Circuit Breakers Important?

Circuit breakers are crucial for several reasons, most importantly for maintaining market stability and protecting investors:

• Prevent Panic Selling: In times of extreme market conditions, traders may panic and sell stocks in a frenzy, exacerbating the market decline. Circuit breakers halt trading temporarily, giving traders time to assess the situation and make informed decisions.
• Market Stability: By preventing dramatic price swings, circuit breakers contribute to the stability of the stock market, promoting investor confidence and ensuring orderly trading behavior.
• Orderly Price Discovery: Circuit breakers allow the market to return to an orderly price discovery process rather than relying on extreme volatility. This allows investors to make more rational decisions based on fundamentals and available information.

Circuit breakers are seen as a critical tool for limiting the risk of a full-scale market crash and providing a buffer against extreme price movements, ensuring that all market participants have a fair opportunity to react to breaking news or developments.

4. History of Circuit Breakers

The concept of circuit breakers was introduced in the U.S. stock market after the **Black Monday** crash of 1987, when the **Dow Jones Industrial Average** lost 22% of its value in a single day. The extreme volatility that day led to the creation of measures designed to prevent such sharp drops in the future.

In response to the 1987 crash, the **Securities and Exchange Commission (SEC)**, along with stock exchanges, introduced the circuit breaker system, which became a critical element of market regulation. Since then, circuit breakers have been expanded and refined to address both individual stock declines and broader market disruptions.

5. Are Circuit Breakers Used Worldwide?

Yes, circuit breakers are used worldwide, although the specific thresholds and rules may vary by country and exchange. Stock exchanges in countries such as India, the U.S., and China use circuit breakers to prevent excessive volatility and ensure smooth functioning of their markets. The basic principles of circuit breakers — halting trading to maintain stability — are common across global markets, although the exact details, such as trigger points and halt durations, may differ.

6. Conclusion

Circuit breakers are an essential mechanism that helps maintain stability and fairness in the stock market. They prevent panic selling and buying, protect investors, and ensure that market movements are orderly. While circuit breakers can’t eliminate all risks, they play a critical role in maintaining investor confidence and preventing market crashes. Understanding how they work is important for anyone interested in the stock market, as it helps you understand how the market responds during periods of extreme volatility.