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Market circuit breakers: everything you need to know

April 2020


Categories: Market uncertainty

As extreme losses take hold, so-called “circuit breakers” are being triggered, particularly in US indices such as the S&P 500. But what are these circuit breakers, and why are they being activated?

Stock markets in the USA have circuit breakers to act as a break on ultra-panicky indices. In times such as these they become an increasingly implemented measure to prevent the total collapse of share prices.

Most recently the S&P 500 was forced to hit the breakers four times in just two weeks as investors furiously sold their investments. The Dow Jones also acted to stop selling on what some are dubbing a new “Black Monday”, the 16th of March 2020.

Simply put, when an index drops by a certain percentage in one day, the market is shut down for trading and a pause takes place. This acts in three stages.

For the first pause to take place in US indices, an index has to lose 7% of its value compared to the previous day’s close. When this happens, the market is stopped from trading for 15 minutes. After this, trading resumes. 

The next halt on trading comes if the index drops 13% below the previous day – but in this case it has to happen before 3.25pm US Eastern Standard Time (ET). Again, it is paused for 15 minutes.

Finally, the most extreme circuit breaker is enacted if the market falls by 20% at any time in the day. This one is the most extreme scenario and would cause the index to close for the rest of the day. 

Circuit breakers have been in place in markets since the 1987 Black Monday Flash Crash. This was the worst day in investment markets’ history. The Dow Jones, as an example, fell 22.6% in a single day of trading.

In the US, the Securities and Exchange Commission (SEC), which regulates US markets, standardised the circuit breaker policy in 2012, so that all markets operate with the same rules. Other countries also have circuit breakers in their indices. For instance the Sensex index in India has similar rules in place, which saw its own circuit breakers engaged on 13th and 23rd of March this year.

The UK however has no such policy in place for its own stock market, the FTSE.

At the time of writing, circuit breakers have been enacted four times on the S&P 500 this year. The first occurred on the 9th March, then again on the 12th, 16th and 18th.

However, considering the circuit breakers in the context of their entire history, it is actually an extremely rare event for markets. This makes the current period of falls and uncertainty pretty exceptional.

The 16th of March 2020 was the most painful day for the S&P 500 in recent times. Over the day it lost 12.93%, falling just short of enacting a second break. In markets history it made for the third worst day on record, after 28th October 1929 (-13.47%), and 19th October 1987 (-22.61%). The 12th March 2020 was the 6th worst day on record at -9.99%.

Markets have been affected by a heady mix. Many analysts point out that companies were overvalued anyway, after one of the longest bull runs in investing history. This, in combination with a shocking medical, humanitarian and economic crisis caused by the coronavirus pandemic has proved a highly dangerous moment. As investors seek to take their cash out of investments a feedback loop of fear has developed.

But this is what the circuit breakers are ultimately for. The idea is that imposing a trading break upon investors, traders and fund managers forces them to take stock of the situation and allows a breather to regain composure. In that sense they are doing their job.

The theory is that they prevents deeper losses. Of course, this is theoretical and it can go on, but so far we are yet to ever experience the third enactment (on a 20% fall) in a single day. As for what happens next for markets, only time will tell as governments around the world gear up to provide an economic backstop to businesses, households and the wider economy.

MM
Author: Mouthy Money Categories: Market uncertainty

Mouthy Money is a money blog with a beating heart and a big mouth. Made of real people talking simultaneously every single day about real dreams, successes and failures. No jargon allowed.