Circuit breakers are measures used by stock markets to prevent panic selling and maintain stability. They involve trading stops with price limits and were developed after the 1987 stock market crash. They are only used when price declines reach certain percentage levels.
Circuit breakers are strategies or measures employed by a stock market when there is a need to avoid the feeling that something catastrophic is about to happen. Sometimes referred to as a collar, the purpose of the circuit breaker is to prevent a panic situation that results in many investors dumping an extreme amount of securities because there is a sense of an impending crash or significant depression in the market. Essentially, the circuit breaker helps form a stopgap solution that keeps a stock market at a more stable level until a more reasonable mindset prevails among traders.
The most common setup for a breaker is to start a series of carefully crafted trading stops with a price limit. In general, price limits are focused on the derivatives and equity markets. By creating this temporary state of slowdown, there is a better chance for the commodity exchange process to continue within healthy levels and not get out of control.
As a strategy to correct a temporary situation within a stock market, the circuit breaker is a relatively new approach. It was only after the minor stock market crash of 1987 that the concept of a circuit breaker was developed. A series of procedures was developed and agreed upon by major stock and exchange markets around the world.
These procedures would essentially involve taking specific measures to curb market activity when price declines reach certain percentage levels. Several markets have provisions for using the circuit breaker approach when dips reach levels of ten, twenty, or thirty percent. The drop is generally based on monitoring activity in the Dow Jones Industrial Average. When a rapid drop hits ten percent, it is likely that at least some of the major markets will implement a circuit breaker approach. However, to date, the strategy has only been used once, on October 27, 1997.
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