Any stock exchange can moderate trade only during its specified trading hours. The trading hours of world’s largest stock exchange NYSE is between 9:30 and 16:00 and that of India’s largest (by means of market capitalization), BSE is between 9:15 and 15:30. There are occasions when the market is too turbulent so that the index may climb steeply or fall sharply. During these occasions, prices of certain shares may spike or plunge in a single day, neither of which is healthy for trade. While sharp falls in prices leads to panic selling, high gains can exhaust liquidity and lead to excessive speculations.
A circuit breaker is a concept whereby trading is halted for a few hours, or in extreme cases, the day’s trade is suspended for a stock if its price increases beyond or decreases below a predetermined value that is calculated based on the previous day’s closing price. Circuit breakers are specific to stock exchanges in that the percentage change in value after which it gets activated varies with stock exchange while some stock exchanges may not even have this concept. For example, BSE has an upper circuit breaker of 20% and a lower circuit breaker of 10%. If a stock closes at Rs.100 on a day and if the stock reaches Rs.120 on the next day, then the circuit breaker becomes active and trading of that stock is halted. Similarly, if the stock falls to Rs.90, again trading is halted.
NSE has more complicated circuit breaker rules, rules that are similar to that of New York Stock Exchange (NYSE). It has three circuit breaker limits: 10%, 20% and 30% of the previous day’s closing stock price. Trade halt duration also depends on the time of the day when the breach occurs.
For a 10% decline in price before 14:00, the halt will be for an hour and for the same decline between 14:00 and 14:30, the halt will be for half an hour and no halt for 10% decline if it occurs after 14:30. For a 20% decline, halt in trading will be for two hours if it happens before 13:00, for an hour if it occurs between 13:00 and 14:00 and if it occurs after 14:00, market will be suspended for the day. In case of a 30% decline, trading will be suspended for the day, whenever the breach may occur.
NYSE first brought out and implemented the concept of circuit breaker after its disastrous experience on October 19, 1987, a day widely known as the black Monday. On that day, the Dow Jones Industrial Average faced a historic drop in index with index falling by almost 22%. There was panic selling everywhere and this event became the trigger for a worldwide stock market crash. The peculiar thing about the incident was that there were no important announcements or news released during the weekend preceding the day, nothing that can be attributed to have caused the crash. Following this incident, NYSE wanted to keep a check on panic selling and have more control over the market and it subsequently devised the circuit breaker. Its usage and success enticed other stock exchanges worldwide and was later widely adopted.
The main purpose of circuit breakers is to curb panic selling. Halting operations for a while gives traders time to think over their options and to reconsider their decision. As a result of circuit breakers, especially to avoid them, traders trade at or slightly above the lower circuit limit and at slightly below the upper circuit limit. Hence it helps in regulating the prices of shares. For example, on January 15th 2009, around 190 stocks in BSE were trading at their lower circuit at as early as 12:00 noon as selling frenzy drove mad the entire market. Had the circuit breaker not been in place, share values would’ve been hit much more.
Moreover as share markets are rapidly changing day by day, circuit breaker categories and levels too change. This is to cope up with the changing trader sentiments and better regulation. Separate circuit breaker levels are set for individual stocks and the overall key index of the stock exchange. For example, apart from day to day fixing of limits for individual stocks, NYSE also sets limits on its key index Dow Jones Industrial Average for a particular quarter based on its value during the month preceding the start of that quarter.