What Is a Circuit Breaker in Stocks and How Does It Work?

In today's market, investors are witnessing significant price swings, with stocks experiencing substantial losses in what feels like the blink of an eye. During such volatile times, it's crucial for investors to understand the mechanisms in place to prevent extreme market declines.

Circuit breakers in the stock market act as these vital guardrails, temporarily halting trading when the market or individual securities experience precipitous drops.

These automatic trading halts are designed to provide a cooling-off period, allowing investors to digest information and prevent panic-driven sell-offs from spiraling out of control.

Understanding how these safeguards work is essential for navigating turbulent market conditions and protecting investments.

What Is a Circuit Breaker in Stocks and How Does It Work?

Think of what is a circuit breaker in stocks as a financial "Whoa, hold on a sec!" button…

If things in the stock market start dropping super-fast, these circuit breakers automatically step in and temporarily stop trading. It's like hitting the pause button on a movie or video game when things get too intense.

Now, how does this "pause button" work in the stock market?

Well, there are a couple of ways…

First, we've got the big market-wide circuit breakers. These kick in when the whole market, or at least a big chunk of it like the S&P 500 index, starts to tank.

There are three levels to this:

• Level 1: If the S&P 500 drops by 7% compared with the day before, trading across all the exchanges will be halted for 15 minutes, but only if this happens before 3:25 p.m. ET.
  
  
• Level 2: If the market keeps falling and hits a 13% drop (that's 6% more after the first 7%), we get another 15-minute time-out, again, only if it’s before 3:25 p.m. ET. You can only have one Level 1 or Level 2 halt per day.
  
  
• Level 3: Now, if things get really hairy and the market plunges by 20%, trading stops for the rest of the day, no matter what time it is. This is the big one!

These market-wide breakers are there to give everyone a breather when the market's having a really bad day. They let folks digest what's going on and maybe stop some knee-jerk selling.

Then there are also circuit breakers for individual stocks, which are called limit up/limit down (LULD)…

These aren't about the whole market crashing; they're about stopping a single stock from going haywire.

So instead of being triggered by a percentage drop from the previous day, these trip if a stock's price moves outside a certain price band for more than 15 seconds.

These bands are set as a percentage above and below a recent average price (usually the average over the last five minutes).

The size of these bands depends on how expensive the stock is and what kind of stock it is (think big, well-known companies versus smaller ones)…

For the big guys (Tier 1 stocks, like those in the S&P 500), the band might be 5% up or down. For less expensive stocks, the bands can be wider.

Interestingly, these bands double in the last 25 minutes of trading because things can get a bit more hectic toward the end of the day.

If a stock price breaks out of this band and stays there for 15 seconds, trading in that stock pauses for five minutes.

Unlike the market-wide ones that mostly react to drops, these individual stock circuit breakers can be triggered by prices shooting up or down.

What Is a Circuit Breaker in Stocks and Why Do We Have Them?

So what is a circuit breaker in stocks and why do we even have them?

Well, the idea really took off after the infamous Black Monday in 1987, when the Dow Jones just plummeted — like a serious nosedive!

That day, the market dropped almost 23%! This scared a lot of people and made regulators think about ways to prevent such a crazy free fall from happening again.

That's when the first circuit breaker rules were put in place in 1988.

Over time, these rules have been tweaked and updated, especially after the "flash crash" of 2010, where the market briefly went nuts and then bounced back super-fast.

This event highlighted the need for better safeguards for individual stocks too.

Even more recently, during the COVID-19 pandemic in March 2020, we saw those market-wide circuit breakers get triggered a few times, showing they're still a relevant tool.

What Is a Circuit Breaker in Stocks and Is It Good?

Now, a lot of folks think circuit breakers are a good thing…

They argue that these pauses can calm down panic selling. When prices drop sharply, people can get scared and just want to dump their stocks, which makes the price drop even further.

Circuit breakers give everyone a moment to take a breath, see what's happening, and maybe make more rational decisions instead of just reacting out of fear.

Plus, these halts can give time for any important news or information to spread, which might help people understand what's going on.

They can also help keep the market from running out of buyers when everyone's trying to sell.

Many believe that the fact we haven't seen another crash as bad as Black Monday since circuit breakers were introduced suggests they're doing their job.

But there are also some arguments against them…

One popular idea is the "magnet effect."

You see, some folks believe that because traders know a circuit breaker will kick in at a certain level, they might rush to sell before that happens, pushing the price down even faster toward the trigger point.

It's like everyone trying to get through a door at the same time when they know it's about to close.

Another concern is that circuit breakers can mess with the natural way prices are set…

In a normal market, prices go up and down based on who's buying and who's selling. By stopping trading, circuit breakers interrupt this process and might stop the market from finding its "true" price quickly.

Some argue this could actually make the volatility last longer. There are also worries about the practical side of things, like making sure the timing of these halts is fair for everyone.

The Bottom Line: What Is a Circuit Breaker in Stocks?

So what is a circuit breaker in stocks in a nutshell?

The bottom line is that it's a safety net that kicks in when stock prices move too dramatically, either across the whole market or for individual stocks.

They're designed to prevent panic and give everyone a chance to regroup.

And while most agree they're a good thing to prevent total market meltdowns, there's still debate about whether they have some downsides too.

Hopefully we don’t see any triggered in the near future so we don’t have to debate their merits at all. But I'd love to hear what you think of circuit breakers in the stock market…

Are they a good thing? Are they bad? What's your take?

Just reply to this email to let me know. Or if you're reading online, shoot me a note by clicking here.