What Are Circuit Breakers And Trading Curbs? Why Is Stock Trading ...

Editor's note: This article was updated in February 2022.

When the stock market sees severe declines, as happened in March 2020 when a global pandemic triggered massive selling in stocks, there are occasional halts in trading. These stoppages are usually referred to as “circuit breakers,” or by their more formal name, trading curbs. The rules are different for individual securities, including stock index futures. They can be halted for extreme movement in either direction, "limit up" or "limit down."

What are circuit breakers and why do they exist?

Put simply, they are exactly what they seem to be. They are times when extreme volatility leads to exchanges closing down completely or not allowing trades in a single security for a pre-set period. They can be triggered by big moves in the market as a whole, or a big drop or jump in an individual security can halt trading in that security alone.

Circuit breakers for the stock market were first put in place following the massive market crash in 1987, when the Dow lost 22.6% in one day. I was in a dealing room on that day and can tell you that in all markets, not just stocks, there was complete and utter panic. Everybody was running, but there was nowhere to hide.

That day brought home to me that as much as those of us in the markets liked to think of ourselves as a bit smarter than the average bear, we were all still human and, as humans, we could be overcome by emotions. When that emotion reached the point of desperate panic, or for that matter of hysterical exuberance, traders need a metaphorical slap in the face.

Circuit breakers provide them.

The nature of the circuit breakers is governed by the ruling body of stock markets and trading, the SEC, and more specifically by their rule 80b. The exact nature of what constitutes a market stopping move has evolved over time. It used to be that three distinct point levels of the Dow, representing losses of 10, 20, and 30%, were set at the beginning of the month and then trading was stopped if they were hit. The most recent iteration of the rule, dating from 2013, uses the broader-based S&P 500 and stops trading at three percentage levels that are recalculated each day, drops of 7, 13, and 20%.

The length of the stoppage depends on which level is hit and at what time of day. Levels one and two trigger a fifteen-minute trading halt, providing they come before 3:25 p.m. After that time, nothing happens until level 3 is hit. A 20% market drop in one day would, whenever it occurred, shut the market for the rest of the day.

The most relevant part of the rules about individual securities for most investors is how they apply to stock market futures. Trading in those contracts, which are widely used as indicators of where stocks will open, is halted on a move in either direction of 5%. The percentages are smaller and the move can be in either direction because futures trading involves a lot of leverage, and because “shorting,” betting on a lower price that would result in big losses on a move up, is much more common in that market.

There is some that question whether, particularly in the modern age of computerized trading, circuit breakers serve any real purpose. The fact is that human actions still ultimately control the market, even if it is just in terms of setting parameters for those computer programs, and the presence of pre-set cooling off levels does have an impact. It may, for example, encourage programmers to build in their own halts at those levels in the knowledge that liquidity will disappear for a while.

From the human perspective, the presence of an endpoint, even a temporary one, to a move down does have an impact. There is always some kind of an end in sight on a big move down, and as such, reduces the chances of total panic gripping the market. That alone makes them both worthwhile and effective, so the next time trading is stopped, think of it not as an interruption, but as a much needed dose of calm being injected into a panicked market.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.