What is a circuit breaker?

Sometimes, the securities market through unusual fluctuations. An extreme dip or spike in the price generates concerns among traders. To safeguard investors from drastic and untimely price changes, the circuit breaker rule is established in financial markets.

What is a circuit breaker in the stock market?

A circuit breaker is a regulatory measure that temporarily suspends trading on an exchange. Circuit breakers are pre-defined percentage values that check for uncontrolled movement in a security or index in either direction. These values are compared with previous closing levels of an index or security.

In India, the Securities and Exchange Board of India is responsible for the formulation and monitoring of the circuit breaker mechanism. Index-based market-wide circuit limits were set up in July 2001. Some modifications were made in September 2013.

Why is a circuit breaker required?

Stocks are driven by sentiment and tend to fluctuate in case of positive and negative news. Negative news may cause the stock price to fall beyond a certain level which can cause fear among investors. The bulk sale of shares may lead the market to crash. Hence, a circuit breaker mechanism is set up to eliminate extreme price movements and curb price manipulation.

What is the circuit limit?

A circuit limit is a price band that includes a lower limit called the lower circuit and an upper limit called the upper circuit. The price of a stock can trade between the price band on any trading day.

The highest price a stock can reach on a trading day is the upper circuit limit. Once the upper circuit limit is breached, there will only be buyers and no sellers. Similarly, the lowest price at which a stock can trade is the lower circuit limit. When a stock reaches the lower circuit limit, there will only be sellers and no buyers.

Thus, if the index or stock breaches the circuit limit then the circuit breaker is triggered automatically. Once it is triggered, trading is halted for the security or index in accordance with the relevant rules and regulations.

Applicability of circuit breakers

Circuit breakers are triggered if the index or any individual security breaches the circuit limits. All trading in the equity and equity derivatives market is halted if the circuit limit for the index is crossed.

What is the duration of the halt?

The duration of the halt is prescribed by SEBI and differs based on the type of circuit breaker. It ranges from an hour to the remainder of the trading day. Markets then reopen with a pre-open call auction session for fifteen minutes after the duration of the halt.

Advantages of circuit breaker

Circuit breakers allow the market to think objectively and avoid panic situations. The halt in trading allows market participants to go through announcements and news and facilitates informed decision-making.

Disadvantages of circuit breaker

The circuit breaker can spread panic since investors are prevented from liquidating their shares at that moment. Nervous investors may even dump their shares in a sliding market before the circuit limit is breached and trading is halted.

Secondly, circuit breakers prevent real-time price movements and result in the market being artificially volatile. It decreases liquidity and simultaneously builds up orders at the limit level. Market experts are of the view that if markets were to move freely without any halts, then they would settle more consistently.

While circuit breakers temporarily reduce market volatility, they cannot completely avoid a fall in the stock markets.

Instances of Circuit Breaker

In India, the pandemic had trigger circuit breakers in March 2020. The SENSEX fell by nearly 10% and the NIFTY plunged by 9.40%. This led to a circuit breaker trigger on BSE as well as NSE and trading was temporarily halted on both exchanges.

On the contrary, in 2009, financial markets in India witnessed a surge in prices, and stock trading was halted since the markets breached upper circuit limits. Before 2009, markets had never breached the upper circuit.

How Does Circuit Breaker Work?

According to SEBI, a stock market circuit is triggered at three stages of index movement i.e. 10%, 15%, and 20%. These percentage levels are revised periodically depending upon the security or index levels over a period.

For example, a stock may have a circuit breaker at 20% for a certain period. The exchange may revise it to 10% subsequently if it deems it fit.

In the case of illiquid stocks securities or as a price containment measure, an exchange may even reduce the limit to 5% and 2% as the exchange deems fit. However, dynamic circuit filters are applied on securities for which derivative products are available.

Trading is suspended immediately after circuit levels are breached. The period of suspension depends upon the rise or fall and when it was halted. Trading resumes after the halt period is completed and business is conducted as usual.

Types of Circuit Breaker

Essentially, circuit breakers may be categorized into the following three types –

1. If the trigger time is before 1 pm then the market halt is for 45 minutes and is resumed with a pre-open call auction of 15 minutes.
2. If the trigger time is after 1 pm and before 2:30 pm then the market halt is for 15 minutes and is resumed with a pre-open call auction of 15 minutes.
3. If the trigger time is after 2:30 pm then there is no halt.

1. If the trigger time is before 1 pm then the market halt is for 1 hour and 45 minutes and is resumed with a pre-open call auction of 15 minutes.
2. If the trigger time is after 1 pm and before 2 pm then the market halt is for 45 minutes and is resumed with a pre-open call auction of 15 minutes.
3. If the trigger time is after 2 pm then trading is suspended for the rest of the day.

The volatility Irrespective of the trigger time, trading is halted for the remainder of the trading day.

Bottom Line

Circuit breakers aid in reducing market volatility and ensures smooth and safe trading. While it may avoid a market crash altogether, it allows traders and investors sufficient time to cope with their loss and take corrective action.