What Is a Circuit Breaker?

Circuit Breakers Explained

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U.S. stock exchanges have procedures in place to help prevent some of the devastating single-day market losses that have occurred throughout history. Circuit breakers are regulatory tools that halt market-wide trading anytime declines reach certain thresholds in a 24-hour period.

Market regulators adopted circuit breakers in 1988 in response to the 1987 stock market crash, in an effort to create a cool-down period during times of extreme market volatility. Most recently triggered in March 2020 as a result of the coronavirus pandemic, these regulatory safety features help prevent panic selling and allow investors the time to better understand what’s happening with the market.

What Is a Circuit Breaker?

A circuit breaker is a regulatory safety net that halts trading anytime S&P 500 losses reach a certain threshold. For example, a circuit breaker may be triggered after a 7%, 13%, and 20% drop of the closing price for the day. Depending on the daily losses, circuit breakers can pause trading for either 15 minutes or the remainder of the trading day. 

While initially intended to apply to the entire market, circuit breakers have since expanded to have stock-by-stock features that can halt trading on a single stock, without shutting down the whole market.

How Does a Circuit Breaker Work?

Circuit breakers are intended to temporarily pause trading during severe market volatility. They create a cooling-off period and, hopefully, prevent a total stock market crash. 

There are three different circuit breaker thresholds in place, which are recalculated daily:

  • Level 1 is triggered when the S&P 500 index declines 7% before 3:25 p.m. on a trading day. If Level 1 is triggered, trading halts for 15 minutes.
  • Level 2 is triggered when the S&P 500 index declines 13% before 3:25 p.m. on a trading day. If Level 2 is triggered, trading halts for 15 minutes.
  • Level 3 is triggered when the S&P 500 index declines 20% at any time during the trading day. If Level 3 is triggered, trading halts for the remainder of the day.

Each circuit breaker level can only be reached once per day. For example, if the S&P 500 index declined 7%, triggering a Level 1 market decline and a trading halt, the exchange won’t halt the market again unless Level 2 is triggered.

When Are Circuit Breakers Used?

Market regulators adopted circuit breakers in response to the stock market crash of October 1987, which came to be known as Black Monday. Although this market safety net has been in place for more than three decades, it’s rarely been used.

The first use of market-wide circuit breakers was Oct. 27, 1997, about 10 years after the procedure was adopted. Over a two-day period, the market fell by 554.26 points. By mid-afternoon on Oct. 27, the Dow Jones Industrial Average had declined by 350 points, triggering a 30-minute halt on trading. The market continued to fall drastically after the halt, causing the markets to close early.

The only other instances of circuit breakers being triggered took place in March 2020. As a result of the market volatility due to the coronavirus outbreak, circuit breakers were triggered four times in nine days. While all four instances triggered a Level 1 market decline, two of the four days are now labeled as part of the 10 largest single-day percentage drops in the Dow Jones Industrial Average’s history.

Pros and Cons of Circuit Breakers

Pros
  • Help to prevent panic selling

  • Give time for analysts to understand what’s happening

  • Can be limited to individual stocks

Cons
  • Could result in traders selling even more quickly

  • Delay inevitable market actions

  • May not be updated regularly

Pros Explained

  • Help to prevent panic selling: The theory behind circuit breakers was that a temporary halt in trading would give people a chance to calm down, prevent emotional selling, and ultimately make more logical decisions.
  • Give time for analysts to understand what’s happening: A rapidly falling stock market gives analysts little time to make sense of the situation. With help from a temporary pause in trading, they have time to catch up.
  • Can be limited to individual stocks: Thanks to updates to the circuit breakers, trading now can be halted on individual stocks experiencing high volatility, without impacting the market as a whole.

Cons Explained

  • Could result in traders selling even more quickly: Circuit breakers could result in the opposite of the intended effect. Rather than giving traders time to cool down before making any buying or selling decisions, people may be tempted to advance a trade at a quicker rate, if they think a circuit breaker will likely be triggered.
  • Delay inevitable market actions: When circuit breakers halted the market in 1997, they simply delayed the inevitable. When the market opened back up after the temporary halts, the decline resumed nearly immediately.
  • May not be updated regularly: Regulators adopted circuit breakers in 1988, and nearly a decade passed before they were first triggered in 1997. Then, more than two decades later, in 2020, the regulators halted the market again. As market conditions change, it’s possible that circuit breakers may not always evolve to keep up.

Key Takeaways

  • Circuit breakers were adopted after the stock market crash of 1987, known as Black Monday. They’ve been triggered on five occasions since then—four of those occasions were in March 2020.
  • Circuit breakers are meant to prevent panic selling and give investors and analysts the opportunity, with cooler heads, to figure out what is happening with the market.
  • Circuit breakers have rarely been tested, causing some critics to argue that they delay an inevitable outcome and, at worst, create even more panic, causing investors to sell more quickly.