By: Montana Timpson
In financial markets, uncertainty often generates volatility, and today’s election presents many potential outcomes with resulting uncertainty. Will the winner be announced on election night? Will there be recounts? Will there be a litigious dispute?
As the U.S. braces for today’s uncertain election results, stock markets around the world potentially face massive volatility. If this results in dramatic movements in global markets, market-related circuit breakers may very well come into play.
What Is A Circuit Breaker?
A circuit breaker is a regulatory mechanism put into place by the U.S. Securities & Exchange Commission to temporarily halt all trading on an exchange. Circuit breakers function automatically by stopping trading when prices hit predefined levels. These trading curbs reduce panic sell-offs on U.S. stock exchanges and are used for individual securities and broad market indexes, such as the S&P 500.
A Brief History
Market index circuit breakers were implemented in financial markets to protect against severe volatility and were first implemented following the 1987 stock market crash known infamously as “Black Monday.”
Between 1987 and early 2013, circuit breakers were only in place for individual securities experiencing dramatic swings in price in either direction. However, since February 2013, the trading halts resulting from circuit breakers also apply to major indices.
As recently as mid-March 2020, market-wide circuit breakers deployed when the Dow Jones fell by over 7% (around 2,000 points) on multiple occasions over fear of the COVID-19 virus and falling oil prices.
Market-Wide Circuit Breakers
Securities and futures exchanges have implemented procedures to temper severe market volatility through coordinated cross-market trading halts to reduce the risk that dramatic downturns may exhaust market liquidity. For example, for the S&P 500, a circuit breaker may be triggered after a 7%, 13%, and 20% intraday move.
When the S&P 500 index falls by 7% below its previous close, it is considered a Level 1 decline. A Level 2 decline refers to a drop of 13%. Lastly, a Level 3 decline refers to a drop of 20%.Level 1 or 2 circuit breakers halt trading on all exchanges for 15 minutes unless they are triggered after 3:25 PM EST (in which case trading is allowed to continue). Level 3 circuit breakers halt trading for the remainder of the trading day (from 9:30 AM to 4:00 PM EST).
Circuit breakers that relate to broad market indices are only triggered based on downward price movements. By contrast, circuit breakers for individual securities can be triggered if the price is decreasing or increasing.
Individual Securities and The Limit-Up Limit-Down Mechanism
“Limit Up-Limit Down” (LULD) is a mechanism designed to dampen extreme volatility and price movements in individual securities and exchange-traded funds (ETFs). The LULD is intended to prevent trades from occurring outside specified price bands for NMS securities. “If the national best bid/offer (“NBB/NBO”) remains at or above/below a band limit for more than 15 seconds, the security is subject to a five-minute trading pause. The primary exchange then holds a reopening auction.
Price bands are set at a percentage level above and below the average price of the stock over the immediately preceding five-minute trading period. Price limit bands are 5%, 10%, 20%, or the lesser of 75% or $.15, depending on the stock price. In addition, price bands double during the opening and closing periods of the trading day. If the stock’s price does not trade back within the price bands within 15 seconds, a five-minute trading pause is implemented.
This LULD system supersedes the previous system that only prevented dramatic losses, but not speculative gains, in a short amount of time. Individual securities are halted according to the following thresholds, in which each percentage change in value occurs within a five-minute window:
The prior trading day’s closing price is used to determine the price range a specific security falls into.
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