The job of a stock market is to provide relatively safe trading opportunities to its participants. Through this efficient process that allows rationing of capital amongst various industries, stock markets permit the economy as a whole to thrive. This is how stock markets are supposed to work in theory. However, in reality, their functioning can be extremely different.

It is a known fact that markets are driven by greed and fear and not by rational analysis. The problem is that sometimes this greed and fear takes over the market to such an extent that it becomes extremely volatile. This volatility is short term.

However, if not interrupted, it can have long term consequences on the participants of the market and the overall economy in general. This is because the financial economy dwarfs the real economy in size. The weekly turnover of the financial economy is greater than the annual turnover of the real economy. Hence, it is essential that the markets be managed effectively!

What Are Circuit Breakers and Why are They Required ?

Circuit breakers are one of these tools created to manage the market economy more efficiently. This system helps by avoiding any major catastrophes in the market. Circuit breakers must be thought of as a temporary halt in trading. This momentary halt is designed to ensure to break the significant upward or downward momentum that is driving the market. Circuit breakers were first introduced in the United States around 1988. They were introduced after the crash of 1987 wiped off a significant portion of the stock market valuation. Later, they have been adopted in many countries with thriving stock exchanges. Some of these countries are India, Japan, and Brazil.

In theory, circuit breakers are supposed to halt mayhem in the market place. The idea is that the growth or decline will be less volatile when the trading is resumed after the session breaks.

The problem is that extreme volatility in the stock market is rare. Hence the number of times these circuit breakers come into play is also less. As a result, it has not been possible to conduct empirical research with a big sample set. However, anecdotal evidence has been enough to persuade some of the most sophisticated stock exchanges in the world to adopt this system.

Market Wide Circuit Breakers

Market wide circuit breakers track an index made up of several stocks. Examples of such indices would be the Dow Jones Industrial Average, S&P 500 index, the Sensex, etc. These indices are made up of 30 to 50 of the largest stocks in the market and reflect the mood of the market as a whole.

The circuits are installed at both lower as well as the higher level. For this calculation, the previous day closing is considered. For example, if the S&P 500 closed at 100 yesterday and the circuit breaker level is 7%, trading must happen between 93 and 107. The upper limit is known as the ceiling, and the lower limit is known as the floor. Together, both the limits are referred to as the collar. If the prices go out of this range on either side, trading will be hated, ideally for a few minutes.

Most markets in the world have three level circuit breakers. Consider SP 500 for example. The first circuit breaker is set at 7%, second at 13% and the third one at 20%. For first and second levels, the trading will be halted for a few minutes whereas, at the third level, the trading will be suspended for the entire day!

Individual Scrip Circuit Breakers

Just like there are circuit breakers for the whole market, there are circuit breakers for individual stocks as well. The regulator decides the stocks on which these circuit breakers have to be introduced. They also decide what can be considered as an acceptable level of volatility.

Like market wide circuit breakers, individual circuit breakers also have three levels. The suspension time increases progressively with the first two levels. The third level causes the trading to be suspended for the rest of the day.

The duration of suspension of trading is also influenced by the time when circuit breakers are reached. For instance, if they are reached at the end of the day, the trading may not be stopped at all. The same exchange can have different circuit breakers for various kinds of stock.

Circuit Breakers and Algorithmic Trading

Circuit breakers are also a welcome risk mitigation mechanism.

Algorithmic trading has gone out of control several times in the past. This has resulted in flash crashes on more than one occasion. When non-human participants indulge in financial activity, some risk mitigation mechanism is required. This is where circuit breakers come in handy. They stop the trading temporarily and give humans time to figure out whether the sudden upward or downward movement is justified by the information in the market or whether it is just a system error which is wiping out billions in market valuation.

To sum it up, circuit breakers are an important risk mitigation mechanism. They help control volatility and preserve wealth from irrational behaviors driven by greed and fear.