What Is A Circuit Breaker In Stock Market?

Who would believe that electrical engineering terminology could rescue financial markets in times of distress? But it does!

A Circuit breaker in stock markets (like a short circuit switch) functions as a control mechanism in times of irrational price volatility. It works like an automatic switch, restricting trading to protect stock market integrity and defend the Retail Investors against quick and unfortunate losses due to unnatural price fluctuations.

Circuit Breaker In Stock Market: Meaning

In free markets like India, individual equities and key Indexes should find their levels based on various technical and fundamental factors. However, when speculators drive share prices in the short term into significant swings leading to market volatility and chaos, the market regulator (SEBI) needs a mechanism by which it can steady the market and bring it under control temporarily to diffuse the situation. 

Thus, SEBI has specified certain thresholds (or price range), pushing the market into a circuit when broken. When this happens, pre-set controls take over, pausing or stopping market trading in the short term.

This threshold level is determined every day, based on the previous day's closing price or Index levels.

Circuit breakers in stock markets have both positive and negative implications.

• On the beneficial side, they function as a 'shock absorber' setting price limits or trading ranges (within the circuit). This is of great value to various participants by dousing market volatility and ensuring against larger losses (i.e., Intraday equity traders, swing and position traders, and medium-term investors). The halt in trading helps relieve volatility and reorient the market closer to normalcy.

• On the negative side, they enforce external controls, bringing down liquidity, transparency, and market depth, adding on costs by forcing position exits, adding to resource reallocation costs, etc. Also, due to the close integration between various financial market wings, circuit breaks have a domino effect on all the parts. This immediately affects the intraday equities traders due to their very short-term positions, which they cannot hold overnight.

How do Circuit Breakers Work? 

Since its introduction by SEBI in 2001, Circuit breaker limits in stock markets are calculated on a daily market-wide basis by both BSE and NSE for three levels (10%, 15%, and 20%), applied to the previous day's closing levels. The levels serve as the range for the next trading day, which is verified for breach after every single trade. 

On detection of any breach of the circuit break limits, the exchanges stop matching orders, call for a halt and remove all pending orders. SEBI has set down for each of the above threshold levels the time duration for:-

• Halting trades and

• Pre-call auction session

Which is to be followed nationwide.

What Are Pre-Open Call Auctions? 

They are allocated sessions during which all orders are keyed in, in an accumulated manner. This is followed by an order matching session at the end before the next normal trading period commences. 

Circuit breaks for individual stocks stop the trading in the specific security or purge execution of pending market orders in that stock if the stock's market price has exceeded a predefined price threshold (applied on the previous day's closing price).

As per SEBI regulations, the following stipulations are applicable by way of threshold:

• Individual scrip-wise price bands up to 20% either way for all scrips in the rolling settlement except for the scrips on which derivatives products are available

• For scrips excluded from the requirement of price bands, stock exchanges have implemented a mechanism of dynamic price bands (commonly known as dummy filters or operating range) which prevents acceptance of orders for execution that are placed beyond the price limits set by the stock exchanges.

• The initial price threshold of the dynamic price bands has since been tightened to 10% of the previous day's closing price for specific securities such as Stocks on which derivatives products are available, Stocks included in indices on which derivatives products are available, Index Futures, and Stock futures.            

At any rate, Circuit breaks for all individual stocks and stock derivatives unilaterally come into force nationwide; whenever an Index is based, Market-wide, the circuit breaker is triggered.

Individual stock exchanges can, however, review circuit filters, within the parameters given above, by increasing or decreasing limits based on their performance and perceived volatilities.

Importance Of Circuit Breakers In The Stock Market

• The innate nature of Stock markets shows day-to-day movements or variations in volatilities. The causes or triggers could be any factor, ranging from macroeconomic changes, geopolitical effects, economic indicators, corporate results, interest rate, and exchange rate movements, not to mention pandemics. 

• While volatility is needed to harness profits, runaway markets lead to settlement defaults and untoward margin calls.

• Circuit breakers in the stock markets give breathing space – in other words, a pause for the market to slow down or stop the volatile trading phase and gain rational thinking. This helps bring back prices to reflect the true underlying value of shares. The use of Circuit breakers stabilizes the market as a whole.

• The SEBI imposed Circuit breakers in India are called Price-Change circuit breakers. Their purpose is to check excessive volatilities. The Circuit breaker benchmark is applied on the movement of Indexes - BSE Sensex or Nifty 50 Indexes - whichever gets breached earlier.

• Thus, undue stock price fluctuation in both directions is kept in check through an Upper and a Lower circuit break.

• The NSE circuit breaker, for instance, is perceived as a good control mechanism that helps reduce wide price movements in times of alarming or unexpected news alerts. The halting of trading enables investors to come to grips with the real impact of news on the performance of companies in the long run. It allows time to get over extreme price reactions and manipulation by certain participants and protects the value of deserving stocks. 

• The protection that the NSE circuit breaker gives to the small investor or the uninformed retail investor is of extreme importance. It prevents the illiquid market from functioning so that the retail trader can postpone his trade decisions for a later time when fundamentals are restored. 

• Both BSE (Sensex) and NSE (Nifty) compute their index circuit breaker limits for 10%, 15%, and 20% levels. These are based on the benchmark of their previous day's closing levels, which are then rounded off to the nearest tick size.

• Given the simplistic method of calculation and application, Circuit breakers are considered the world over as a practical method of steadying prices when faced with catastrophes. 

Conclusion

• All in all, with both pros and cons attached to Circuit breakers in the stock market, traders take comfort from the knowledge that in the last 20 years of its imposition, not more than half a dozen times have they been triggered. Hence, only on rare, vital occasions were their market shuts, reducing the trading intensity or lower depth in the markets. 

• Viewing Circuit breakers as allies, you can open a free Demat account with us and take advantage of this useful tool in controlling price fluctuations and protecting your portfolio against whipsaws due to large players moving markets. 

• Open a free Demat account with the knowledge that Circuit breakers would be automatically triggered, giving time to make better-informed decisions during the trade shut-down period. Any market with this in-built loss limit strategy (e.g., BSE or NSE) ensures that normalcy is returned and true price discovery prevails, empowering traders with a good risk control measure.

• It is said that Safety is Common Sense and Compliance working together. For the Safety of investors in India, Compliance through Circuit breakers goes a long way in making share trading lucrative and shielded.