Circuit Breakers: Emergency Brakes for the Stock Market

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On Wall Street, “circuit breakers” refer to stock market shutdowns that keep markets from spiraling out of control when prices fall too quickly. These circuit breakers indicate excessive short-term volatility, but they shouldn’t worry long-term investors.

According to NYSE President Stacey Cunningham, circuit breakers “are designed to slow down trading for a few minutes, to give investors the opportunity to understand what’s happening in the market, consume the information, and make decisions based on market conditions”.

You may remember the successive circuit breakers that hit stocks in March 2020. Amid growing uncertainty over the COVID-19 pandemic, markets suffered a series of crashes that tripped the circuit breakers four times in two weeks. Prior to this, circuit breakers like this had not been used for over 20 years.

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How do circuit breakers work?

Market-wide circuit breakers are based on declines in the S&P 500 index during a single session. The brakes are triggered at three different thresholds: after a 7% drop, a 13% drop and a 20% drop. For declines of 7% and 13%, trading is only halted for 15 minutes, but if the S&P 500 Index (^GSPC -0.08%) down 20%, trading is halted for the rest of the day. Stock exchanges work with futures and options markets to activate and coordinate these market-wide circuit breaker stops.

The market can also put the brakes on any individual stock with Limit Up-Limit Down (LULD) circuit breakers. These are triggered if the price of a stock rises or falls outside the specified price ranges, set at 5%, 10% and 20%, during the previous five minutes of trading. Single stock circuit breakers are much more common and occur every day. Unlike market-wide circuit breakers, LULD circuit breakers are designed to limit both panic selling and its opposite, “maniacal buying”.

History of circuit breakers

Wall Street implemented market-wide circuit breaker stops in 1988 in response to the Black Monday crash of October 19, 1987, when the Dow fell more than 22%.

After Black Monday, President Reagan appointed a task force called the Brady Commission to prevent such a crash from happening again. The Brady Commission proposed that a system of circuit breakers be put in place to prevent future stock market crashes.

Causing frequent shutdowns throughout the market in their early years, circuit breakers went full throttle on October 27, 1997, when a global “mini-crash” occurred. This has led market regulators to make major adjustments to circuit breakers, including moving from point thresholds to percentage thresholds.

Since 1997, market-wide circuit breakers have only been tripped four times, all in March 2020.

Are the circuit breakers working?

While you could argue that imposing price controls on a market makes it less free, circuit breakers seem to make sense. In the four times they were implemented in March 2020, three of the stops were deemed successful, with the S&P 500 stabilizing around the 7% mark. However, on March 16, after the initial 7% decline trigger, the market continued to trade at nearly double that shortfall. Not perfect, but three out of four isn’t bad.

“Circuit breakers cannot produce miracles,” wrote Brady Commission Chairman Nicholas Brady and Executive Director Robert Glauber. “They may just provide ‘respite’, a chance to interrupt the panic.”

No one knows when the circuit breakers might trip again, halting a dramatic market drop. But long-term investors probably shouldn’t worry about trading restrictions and market stops. After all, the S&P 500 has more than doubled since those emergency brakes were last activated.

Foolish contributor Micah Angel holds no financial positions in any of the companies mentioned. The Motley Fool has no position in the stocks mentioned. The Motley Fool has a disclosure policy.

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