Emergency Stop: Circuit Breakers Explained

red fire alarm station attached on brick wall

Recently, the markets have been incredibly volatile. With stock prices moving violently up and down (mostly down) without pause. On any given day, a 10% change in either direction.

This is a time of great uncertainty and investors hate uncertainty. Many will panic and sell, retreating to the safety of cash. With more sellers than buyers, there's a downward pressure on prices. When prices fall, more investors panic and start selling too.

This vicious cycle can lead to disaster. To prevent this, or at least to soften the landing, regulators have controls in place.

Taking A Break

A circuit breaker is a temporary pause in trading, enforced during wild market conditions. The idea is to give traders a chance to take a step back so they can make better, more informed decisions.

Circuit breakers apply to broad market indices as well as individual securities.

Market Level Circuit Breakers

Circuit breakers are trigged at a predetermined levels. The S&P 500 for example has three levels: price movements of 7%, 13%, and 20%.

Level 1: When the index moves 7%, trading is halted for 15 minutes.

Level 2: When movement reaches 13%, trading is halted for another 15 minutes.

Level 3: When movement reaches 20%, trading is done for the day. We've seen enough!

Circuit Breakers For Individual Securities

For established companies like Amazon and Google, when movements reach 5% trading will pause for 5 minutes. The threshold is increased to 10% for the first and last 15 minutes of the trading day as this is when markets move most.

For riskier, less established companies (such as stocks less than $3), the movement allowances are much wider.

Do They Work?

Some critics have argued that circuit breakers can create more volatility. Artificially pausing markets introduces a reduction in liquidity and limits price discovery. It may also encourage additional buying and selling as traders try to avoid getting stuck in unfavourable positions when a halt is near.

There's not enough evidence to draw a definitive conclusion. Ultimately, the idea is sound. Don't get caught up in the hysteria, take a breather and make decisions from a rational place. If you're investing for the long term, with a risk-appropriate portfolio, short-term volatility doesn't matter. The news can be scary, but ultimately it's just noise. Stay healthy out there.

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