We can think of the circuit breaker mechanism as a โfuseโ. When the market fluctuates too violently, the fuse will melt and break, suspending trading activities in the market temporarily. Trading will resume after a while.
During the trading hours of the U.S. stock market, if market prices fluctuate violently to a certain preset limit (the circuit breaker point), trading will be temporarily suspended and will resume after a while.
The first circuit breaker in the U.S. stock market occurred on October 19, 1987, when the Dow Jones Industrial Average fell nearly 23%, triggering the circuit breaker.
1. Why is there a circuit breaker mechanism?
When the market experiences severe fluctuations, trading is forcibly paused for some time. since panic causes liquidity to tighten and prices to change drastically.
The pause allows everyone to โcalm downโ for a while before trading resumes, with the expectation that liquidity will recover.
Liquidity Quality refers to how easily investment targets can be freely bought and sold.
Many believe that the circuit breaker mechanism is designed to prevent the spread of panic. However, I believe that the circuit breaker is not intended to limit the extent of a downturn or to reduce panic, but rather to restore liquidity.
By pausing for a while, it allows buyers and sellers to regroup, facilitating more trades.
After all, a market with no liquidity, where transactions cannot occur at all, is far more terrifying than a significant market drop.
2. How does the U.S. stock index circuit breaker mechanism work?
Trigger Conditions: During market hours, the mechanism is triggered at the following drop levels: โ7%, 13%, 20%.โ
After Triggering: At 7% and 13% declines, the market will pause trading for 15 minutes before resuming. If thereโs a 20% fluctuation during the day, the market will close for the day.
Generally, an index comprises numerous companies. The S&P 500 index includes 500 large American companies. Hence, a 7% decline indicates an average drop of 7% among these 500 firms; in some cases, the fall might exceed 10% to reach such a level, which is not easy to achieve; let alone declines of 13% or 20%, which signify very extreme situations.
Suppose the index opens at 2800 points.
If it falls by -7% to 2604 points, the first circuit breaker is activated, pausing trading for 15 minutes.
After trading resumes, if it falls again by -13% to 2436 points, the second circuit breaker is activated, pausing trading for another 15 minutes.
After trading resumes again, if it falls by -20% to 2240 points, the third circuit breaker is activated, closing the market for the day, with trading resuming the next day.