Finance

Circuit Breaker

Circuit Breaker

A circuit breaker is a safety feature that prevents significant price fluctuations in a short period of time. When the price changes above or below the cap, trading on the market is stopped. Circuit Breakers are placed to curb panic-selling. They are used in broad market indexes, such as the S&P 500. They are also used for individual securities.

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The very first market-wide circuit breakers were introduced in the United States following Black Monday in the year 1987 when the Dow Jones Industrial Average (DJIA) fell by 22% with one day. The use of circuit breakers is not new in India, as the Indian stock market has experienced several highs and lows, causing trading to halt. Circuit breakers function automatically by stopping the ongoing trade in the exchange when prices hit predefined levels. The index-based market-wide circuit breaker mechanism is enabled at three levels of index movement, namely 10%, 15%, and 20%. When these circuit breakers are triggered, all equity and equity derivative markets around the country come to a halt. The BSE Sensex or the Nifty 50, whichever is breached first, triggers the market-wide circuit breakers.

How do they work?

The circuit breaker system applies to both individual securities as well as market indexes. For example, since February 2013, there have been circuit breakers throughout the market that respond to single-day declines in the NIFTY 500 index. When the index falls by 10% below its previous close, it is considered a Level 1 decline. A Level 2 decline refers to a drop of 15%. Finally, a 20 % drop is referred to as a Level 3 decline. For individual securities, they can be triggered with an increase or decrease in the price. By contrast, circuit breakers that are related to market indices are only triggered seeing the downward price movements. There are theories that circuit breakers are disruptive and keep the market artificially volatile because they cause orders to build at the limit level and decrease liquidity. Critics also argue that if the market were allowed to move freely, without any breakers, they would settle into a more consistent equilibrium.

Trigger limits and duration in NSE:

Following an index-based market-wide circuit filter breach, the market will reopen with a pre-open call auction session. The exchange shall compute the Index circuit breaker limits for 10%, 15%, and 20% levels on a daily basis based on the previous day’s closing level of the index rounded off to the nearest tick size.

Drawbacks of Circuit Breakers:

  1. They prevent true price discovery in stock both on its way up or down, at least for the limited time period they are imposed.
  2. They allow early investors (usually well-informed institutions or also traders) to gain advantage and make a move before circuit breakers are eventually invoked, which restricts the moves of other investors, who wait until later in the day to make a move (usually retail investors).

Author: Mahek Medh

About the Author: Currently, I am in my second-year bachelor’s program and over the period of time I have realized that I enjoy learning about numbers and money, and I find topics of Finance to very interesting thus this is the domain and space where I wish to etch my long term career.

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