What is a Circuit Breaker?

Stock market volatility can be nerve-wracking for investors. Seemingly out of nowhere, share prices can swing wildly, wiping out portfolio gains in a matter of minutes. As an investor, watching your hard-earned money evaporate so quickly is not only financially painful but also emotionally draining. Is there anything that can be done to manage such turbulent times? 

Read on to understand what circuit breakers are, how they work to stabilise markets during times of stress, and their advantages and limitations in protecting investors. With this knowledge, you’ll be better equipped to navigate periods of high volatility in the stock market.

What is a circuit breaker?

In simple terms, a circuit breaker temporarily halts trading on an exchange when prices swing too far, too fast. There are certain rules set by the Securities and Exchange Board of India (SEBI) that help to keep the stock market stable. If the standard index of the stock market falls by 10%, 15%, or 20% compared to the previous day’s closing value, then a circuit breaker is activated. This means that trading is paused for a certain amount of time to help prevent panic selling or other market disruptions. 

The idea is that a temporary pause in trading gives investors a chance to digest information driving the sharp price moves, assess their positions, and make rational decisions. It prevents things from spiralling out of control due to panic, much like how circuit breakers in your home prevent electrical fires by cutting power when abnormal currents flow.

Types of circuit breakers

SEBI has defined the following three levels of circuit filters to manage excessive volatility:

1. 10% trigger: If there is a problem with the trading system before 1 pm, trading stops for 45 minutes. If the issue happens between 1 pm and 2:30 pm, trading stops for 15 minutes. However, if the problem occurs after 2:30 pm, trading will continue as usual without any break.

2. 15% trigger: A 1 hour 45 minute halt if breached before 1 pm. Between 1 pm and 2 pm, trading halts for 45 minutes. No trading after 2 pm.

3. 20% trigger: Trading stopped for the remainder of the day regardless of when the circuit is hit.

As you can see, the halt gets longer if circuits are hit earlier in the day. This prevents premature closures while markets still have room to recover intraday. The briefer pauses in afternoon trading recognise that investors have had sufficient time to digest information by then.

Uses and workings of a circuit breaker 

Circuit breakers have some key uses:

• Calming investor panic: An extended trading halt allows everyone to breathe and assess events calmly before reacting. This prevents irrational, knee-jerk selling.
• Curbing speculators: With upper and lower limits in place, circuit breakers prevent traders from driving prices to unreasonable levels through sheer speculation.  
• Buying time: For listed companies, trading curbs allow time to issue clarifications if there are rumours or unverified news influencing stock direction.
• Maintaining market integrity: By briefly limiting liquidity, circuit breakers reduce the ability of a few players to manipulate prices during periods of panic demand or supply.
• Shielding retail investors: Small investors with limited loss absorption capacity are shielded from heavy meltdowns.

How do circuit breakers work in practice? 

Let’s say the benchmark index slips 9% by noon compared to yesterday. Now, if it falls a further 2.5% within a short span from there, the 10% lower circuit will kick in, suspending trading for 45 minutes. 

When trade resumes, two scenarios can unfold:

1. If market momentum continues downward after opening, the next circuit level of 15% will halt proceedings for 1 hour 45 minutes if before 1 pm. 

2. If buyers emerge, pushing the index back above a 10% fall, trades continue without disruption as the circuit has not re-triggered.

Circuit filters thus act as automatic stabilisation controls rather than completely stopping slides. Declines only halt if circuits get freshly triggered post the cooling-off pause.

The pros and cons 

While circuit breakers are valuable speed breakers during volatile times, they need to be foolproof safeguards. Just like medicines, they come with some side effects. Let us weigh the pros and cons of circuit breakers:

Potential benefits

• Prevents panic spirals: Trading halts nip momentum-based selling in the bud before it assumes crazy proportions.

• Arrests speculators: Breaching upper and lower limits becomes difficult with curbs in place.

• Safeguards investors: Small investors are especially shielded from sharp single-day crashes exceeding 20%.

Drawbacks to consider

• Builds selling pressure: Anxious investors may rush to sell before circuits kick in. This snowballs momentum.

• Increases volatility later: When trading resumes after a halt, pent-up orders on both sides could trigger violent swings.

• Reduces liquidity: Circuit filters reduce market depth since orders accumulate at halt levels. This leads to bigger slides when selling emerges.

In essence, circuit breakers are like speed breakers. They don’t prevent accidents but reduce their intensity. While valuable, their work has some less obvious ripple effects to be aware of.

Striking a balance

Markets tread a fine line between ensuring investor protection and maintaining efficient price discovery. Circuit breakers are meant to strike a balance without being overly restrictive. Their primary aim is to prevent huge crashes stemming from mass panic or manipulation. 

At the same time, their temporary nature gives markets room to find genuine equilibrium through free buyer-seller interaction. Prices can’t rise or fall forever if the underlying value remains intact. So smart investors use circuit-triggered suspensions smartly to reorient themselves.

Rather than waiting for triggers to halt trading automatically, it is best to control risk using stop losses proactively. That way, you book profits during good times without wiping out capital through greed. And during corrections, exit early without hoping circuit filters will rescue investments.

Over multiple decades, SEBI has continually refined market safeguards, balancing both stability and liquidity needs. Learning to harness rather than curse volatility is the hallmark of market masters. Equipped with the right perspective, knowledge, and risk controls, both professionals and retail participants can prosper.

Conclusion

Circuit breakers are an invaluable mechanism to maintain orderly markets during times of unexpected volatility spikes. But they aren’t foolproof safeguards against prolonged downturns and must be supplemented with disciplined risk management. Used judiciously, they grant much-needed breathing space for investors to gather their senses when volatility goes haywire.

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