What Is A Circuit Breaker?

If you started investing at any point after the 2008/2009 economic crash, then you probably have little to no knowledge of what a circuit breaker is -- even if you're an electrician. Now it's a phrase that investors will have seen crop up time and again as the coronavirus wreaks havoc on the market. 

Google (NASDAQ: GOOG) will not provide much insight either: "A circuit breaker is an automatically operated electrical switch designed to protect an electrical circuit from damage caused by excess current from an overload or short circuit." 

Factually correct, contextually wrong. For in the stock market, a circuit breaker refers to a regulatory measure that temporarily halts trading on an exchange such as the S&P 500 (NYSEARCA: VOO), the Nasdaq (INDEXNASDAQ: .IXIC), or Dow Jones (INDEXDJX: .DJI). 

Uncertain about Wall Street jargon? Check out some more of our articles: 

• What Is A Bear Market?
• What Is A P/E Ratio? And Is It A Useful Metric?
• What Is A Dead Cat Bounce?

How does a circuit breaker work?

The first circuit breaker was triggered on October 19, 1987; otherwise referred to as 'Black Monday. The Dow had just shed more than 22% in a single day, and it is now widely regarded as one of the worst days in Wall Street history. The circuit breaker did allow stocks to recover that day, but the crash continued throughout the week, forcing regulators to constantly tinker with the system.

Our current system has been in place since February 2013 and is split into three levels: 

• Level 1 of the circuit breaker halts trading on all exchanges for 15 minutes if the S&P 500 falls more than 7% below its closing price from the previous day.

• The Level 2 circuit breaker triggers if the S&P 500 falls another 6 percentage points, or 13% below its closing price from the previous day.

• Level 3 is the final threshold for the circuit breaker and triggers if the market falls 20% from its previous close. This shuts down trading for the rest of the day.

There are many different types of circuit breaker in the market now. For individual securities, which can be anything from a company's stock -- Apple (NASDAQ: AAPL) or Microsoft (NASDAQ: MSFT) for example -- to an ETF, a circuit breaker can be triggered by a massive stock jump, whether it's up or down. This is in comparison to circuit breakers that relate to broad market indices, which are only triggered based on downward price movements, such as on Black Monday.

In March 2020, the circuit breaker was triggered a number of times, including on March 9 and 16, as the coronavirus pandemic caused a widespread market sell-off. 

Why is the circuit breaker in place? 

The function of the circuit breaker is essential to give everyone a moment to calm themselves down and try to remove emotion from the equation. In times of great turmoil, where panic selling takes hold and the stock market goes into freefall as it has in recent weeks, the circuit breaker is intended to force trading to halt in order for the freefall to be curbed. 

Unfortunately, the opposite effect can take hold with such measures, as traders proceed to panic at the thought that things have gotten so bad that a circuit breaker must be used to manage the madness. Who can blame them really, when it is a system born from the most devastating crash in the market's history? 

The jury is definitely still out on circuit breakers and their uses in the stock market, with many traders complaining that it does nothing more than add to the market's volatility and disrupts the natural flow of the marketplace. Others will argue that it prevents a devastating rout from taking place.

MyWallSt operates a full disclosure policy. MyWallSt staff currently hold long positions in companies mentioned above. Read our full disclosure policy here.