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Circuit breakers are measures used by stock exchanges to prevent panic selling during a potential market crash. They involve trade stops and price limits to slow down market activity and maintain healthy levels. The concept was developed after the 1987 stock market crash and is only used when price falls reach certain percentage levels. The strategy has only been used once, in 1997.
Circuit breakers are strategies or measures that are employed by a stock exchange when it needs to avoid the feeling that something catastrophic is about to happen. Sometimes referred to as a collar, the purpose of the switch is to prevent a panic situation that results in many investors dumping an extreme amount of stock because there is a sense of an impending crash or significant depression in the market. In essence, the circuit breaker helps form a filler that keeps a bag on a more even keel until a more reasonable mindset prevails among traders.
The most common setup for a circuit breaker is to initiate a series of carefully crafted trade stops with a sprinkling of price limits. In general, price limits focus on derivatives markets and equities. By creating this temporary state of slowdown, there is a better chance that the commodity exchange process will continue within healthy levels and not spiral out of control.
As a strategy for correcting a temporary situation within a securities market, the switch is a relatively new approach. It wasn’t until after the minor stock market crash of 1987 that the concept of the circuit breaker was developed. A number of procedures have been developed and agreed upon by major stock and exchange markets around the world.
These procedures would essentially imply taking specific actions to slow market activity when price falls reach certain percentage levels. Various markets have provisions for using the circuit breaker approach when drops reach ten, twenty or thirty percent levels. The decline is usually based on monitoring activity on the Dow Jones Industrial Average. When a rapid decline reaches ten percent, a circuit breaker approach is likely to be implemented by at least some major markets. However, to date the strategy has only been used once, on October 27, 1997.
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