A trading curb, also referred to as a “circuit breaker” is a mechanism to help prevent the market from crashing during extreme volatility. When they are triggered, circuit breakers either halt trading for a certain period of time, or close the trading day early to allow investors and market makers to assess their positions and make informed decisions in an orderly fashion.
The New York stock Exchange (NYSE) has a trading curb/circuit breaker that was implemented after Black Monday in 1987. This was put into place on order to reduce massive sell-offs by investors. Black Monday is well-remembered by those who were trading on October 19, 1987, when the Dow Jones Industrial Average (DJIA) dropped over 500 points, almost 23%, in one day.
The intent of a circuit breaker is also to allow time for sufficient communication between institutional traders and market makers. The Securities and Exchange Commission (SEC) made this circuit breaker mandatory on U.S. stock exchanges. The SEC ruling named the circuit breaker Rule 80. Rule 80 outlines the specifics of the circuit breaker and the various price limits for investors.
The original circuit breakers in 2008 were based on a Dow Jones Industrial Average (DJIA) points-based system. In an amendment to the ruling in 2013 (Rule 80B), the Dow Jones Industrial Average points-based system was changed to a percentage change system that is based on the S&P 500 (SPX).
The amendment of rule 80B has three tiers of thresholds, each with different protocols, for halting trading and closing the market.
At the beginning of each day, the NYSE sets the three circuit breakers at the percentage levels outlined below. These levels are based on the previous day's closing value of the S&P 500.
Circuit breakers include timing for trade halting for the various levels
Level 1 (7% decline)
The 7% threshold results in a 15-minute halt to trading. If the decline occurs after 3:25 pm or 12:25 pm on a day of a scheduled early market close, trading is not halted.
Level 2 (13% decline)
The 13% threshold has the same timing built in as Level 1.
Level 3 (20% decline)
A level 3 drop will result in trading being suspended for the remainder of the trading day.
Levels 1 or Level 2 circuit breaker can only occur once each per trading day. As an example, if the market reached Level 1 (7%) decline which curbs trading, the market would not be halted again that day unless the next threshold, Level 2 (13%), were to occur in the same day. Also, if trading was halted because of a Level 2 decline, after re-opening trading would not be halted again that day unless a Level 3 drop were to occur.
There are numerous ways a trader can protect their portfolio from a massive loss in the event one of the circuit breakers triggers, depending on your account size and how much you feel you would be willing to lose should Level 2, 3, or even 3 occur. It's important for each individual trader to assess his/her own situation and plan according for a worst-case scenario. Some traders choose not to have an overall portfolio hedge, having the plan they will just exit existing positions if a massive drop occurs. More conservative traders may choose to have something in place that will lessen the pain, at a relatively low cost, if Rule 80B occurs.
If you have thoughts you would like to share on how you hedge your trading portfolio, feel free to comment below.
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