Circuit Breakers

I was working for corporate America back when stocks crashed on Black Monday in 1987. While I was not even remotely interested in stocks and therefore oblivious to the market, I knew something horrible had happened, just by the outrage on the street. That chatter around the water cooler was doom and gloom as to how the Dow Jones Industrial Average dropped by more than 20%, putting the market in a state of chaos. Clearly, there were signs of dysfunction.

Such an event led regulators to implement a tool that would pause the market and let everybody take a deep breath. This facilitated the ability of traders to gather some information so they could make more informed decisions, rather than resorting to trading in a panic.

Through several iterations and modifications to the design, the circuit breaker as we know it has only been triggered once since its initial adaptation. That was on October 27, 1997, when the S&P 500 fell 6.86%, the Nasdaq dropped 7% and the Dow moved down 13.3% off its high. Some analysts saw this crash as a “correction” to the overheated markets, which had doubled in value in 30 months.

Then, the onset of the COVID-19 pandemic sent markets in a panic mode, triggering a circuit breaker four times in 10 days as prices collapsed the day the World Health Organization declared a global emergency.

The term “circuit breaker” refers to the emergency-use regulatory measure that temporarily halts trading on an exchange. It is designed to curb panic selling or manic buying. They can be used for individual securities as well as broad market indexes, like the S&P 500. They are triggered automatically when prices hit predefined levels within a period of time. For the S&P 500, there are actually three points when it kicks in, should
trading get overloaded.

Level One decline is when the index falls by 7% below its previous close, halting trading for 15 minutes. Level Two stops all trading for another 15 minutes if the drop is 13%. If these are triggered after 3:25 p.m., trading can continue for the rest of the day. Finally, Level Three decline of 20% halts trading for the rest of the day.

Exchange-traded funds are considered as individual securities under the circuit breaker system. There are special considerations as well. But by and large, this tool is to preserve the integrity of the markets. Under Securities and Exchange Commission (SEC) rules, a stock needs to be paused if it moves greater than 5%, 10% or 20% from the previous day’s close. There are rules attached, depending on the type of security.

If a circuit breaker is activated, it also affects the options market, nullifying any trades that occurred after the halt was triggered.

Circuit breakers have a dark side in that they generally lower overall price levels and substantially alter price dynamics. As the market drops closer to the trigger threshold, volatility rises sharply while returns exhibit negative skewness with an increasing magnitude, effectively further destabilizing the price during large market declines. The closer the price drops to the trigger point, the stronger the likelihood a trigger rises exponentially. Like a magnet, it attracts more sellers not wanting to be stuck in their positions when trading is halted. As more sellers step in, prices drop further and faster in a self-fulfilling prophecy.

It is for this reason that we — and many other traders — take a back seat with regard to trading, lest we be caught in this whirlwind of sellers. If/when you see our Pick of the Day predictions report a “No Trade Day”, it may well be for this phenomenon. In other words, take heed as we are protecting you from a potentially disastrous situation. “It’s better to not be in a trade wishing you were than to be in a trade wishing you weren’t.” Never fret missing an opportunity; the market delivers them many times every day.

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