What Are the Stock Market Circuit Breakers?

What Are Stock Market Circuit Breakers?

A stock market circuit breaker is a type of trading curb, a tool used by stock exchanges to slow severe declines in the U.S. stock market. Curbs temporarily stop trading to give investors time to reassess the situation and make trading decisions based on information rather than panic.

There are different types of curbs including circuit breakers, trading halts, and a limit up-limit down, or LULD plan. Trading curbs can differ from market to market.

Stock market trading curbs

In this post, we’ll focus on stock market trading curbs. Let’s start with the one that grabs the most headlines: market-wide circuit breakers. Circuit breakers were introduced by the New York Stock Exchange, or NYSE, in 1988 in response to the 1987 Black Monday crash, when the Dow Jones Industrial Average dropped 22.6% in a single day.

Since then, other exchanges and markets have incorporated circuit breakers. When a circuit breaker is triggered, all trading stops for a certain amount of time nobody can buy or sell securities on the stock market during this period.

There are three levels of market-wide circuit breakers:

  • Level 1 is a 15-minute halt that occurs if there’s a 7% loss in the S&P 500 from the closing price of the previous day.
  • Level 2 is triggered at 13%, and trading is halted for an additional 15 minutes.
  • A level 3 circuit breaker occurs at a 20% drop, and trading is stopped for the rest of the day.

No circuit breakers are allowed after 3:25 p.m. Eastern Time unless Level 3 is triggered. On March 9, 2020, the S&P 500 fell 7% in response to news of the deadly COVID-19 pandemic and falling oil prices. This decrease triggered a level 1 circuit breaker, pausing trading for 15 minutes.

More circuit breakers were triggered on March 12th, March 16th, and March 18th. These were the first market-wide circuit breakers in nearly 20 years.

Trading halts

In addition to market-wide circuit breakers, trading can also be halted on individual exchanges due to technical problems or regulatory concerns.

In July 2015, the NYSE was shut down for three and a half hours for technical issue but was resolved before the market close. 

In July 2009, the NYSE closed for 15 minutes because of system irregularities.

In June 2001, trading was halted for a connectivity problem. Perhaps the most common trading curb is a security-specific trading halt, which temporarily stops trading on a single security. Exchanges typically institute a trading halt in anticipation of a news announcement that has the potential to cause a drastic stock move in order to give investors time to absorb the information. 

For example, on May 19, 2021, Century Communities ticker symbol CCS trading was halted for 73 minutes in anticipation of a news announcement that CCS would start paying a dividend that yielded more than double its peers. When trading resumed, the stock price jumped on the news.

To resume trading after a halt, the exchange will hold an auction to find willing buyers and sellers. Traders must be patient as price discovery takes place. When trading resumes, the stock price could still be quite volatile.

Limit up-Limit down (LULD) Curb

Another trading curb is the LULD or limit up-limit down plan it’s like a circuit breaker for an individual stock. The LULD plan is designed to avoid extreme volatility by keeping trades within a specified range. If the price breaks a certain level for 15 seconds, trading halts for five minutes. It gives investors a timeout to reconsider their position.

The levels are determined by percentage bands that are set above and below the reference price, which is the average price of a security over the previous five minutes. The bands are continuously calculated on a rolling five-minute average. Bands are determined by tiers.

Tier 1 includes all stocks in the S&P 500, Russell 1000, and select exchange-traded products. The price of the stock helps determine the percentage bands’ settings. If the stock price is greater than $3, the bands are set at 5%. Bands for stocks priced between $0.75 and $3 are set at 20%. And stocks below $0.75 have bands set at 75% or at 15 cents, whichever is lower.

Tier 2 includes all other stocks traded on the National Market System, or NMS. The NMS includes all entities and facilities used by broker-dealers to execute trades. The bands for stocks greater than $3 is 10%. Lower-priced stocks are the same as tier 1.

Price bands are doubled for both tiers during the last 25 minutes of trading. If a pause occurs in the last 10 minutes of the trading session, the security will not be traded for the rest of the day.

Let’s look at an example. On May 11, 2021, Virgin Galactic Holdings ticker symbol SPCE rallied big on the open, erasing previous losses of 20%. At 9:35 a.m. Eastern Time, the stock hit its upper band, and trading was paused for five minutes.

What’s an investor to do during market halts and LULD events?

If you’re a buy-and-hold investor, a market-wide circuit breaker could be a good reminder to review your portfolio to ensure you’re comfortable with the level of risk. For individual trading halts, long-term investors could likely ignore the day-to-day volatility and focus on their long-term goals.

However, active and day traders may want to use these events to re-evaluate their positions and their overall investment plan. Investors can still enter orders during stoppages. The order will go into a queue and be filled when trading resumes. However, different order types can provide certain benefits or risks.

An investor who wants out of a trade as soon as possible could use a market order, but the price at which it is filled could be higher or lower than expected. A limit order allows an investor to designate a price to close the trade at. However, if the actual stock price doesn’t reach the limit price, the order won’t be filled, and the investor will still be in the position.

There’s also a possibility that even if the price is reached temporarily, it may not be able to be executed in full. Finally, a stop order allows an investor to designate an activation price for an order. Once that price is hit, the order becomes a market order and will compete with other market orders to fill at the next available price.

This fill price may not be near the activation price and may fill at a much lower price. Each order type has particular benefits and risks that investors should consider.

While trading curbs are designed to reduce and slow market selloffs, they don’t stop your investments from losing value. Investors should be aware of these tools and develop a strategy for exiting short-term trades.

Leave a Reply

Your email address will not be published. Required fields are marked *