What is a circuit breaker in the stock market?

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What is a circuit breaker in the stock market?

In the context of the stock market, a circuit breaker refers to a set of predetermined rules and mechanisms implemented by stock exchanges to temporarily halt or limit trading activity during periods of extreme market volatility. The purpose of circuit breakers is to provide a brief pause in trading to allow investors to digest information, reassess their positions, and prevent panic-selling or irrational trading behavior.(What is a circuit breaker in the stock market?)

Circuit breakers are triggered based on specific thresholds or criteria related to market declines or volatility. When these thresholds are met, trading is halted for a specified period of time. The specific rules and thresholds can vary depending on the stock exchange and the country in which it operates.

The key objectives of circuit breakers are:

• Volatility Control: Circuit breakers help manage excessive market volatility by temporarily halting trading when prices experience significant swings. This pause allows market participants to regroup and reassess their strategies.

• Investor Protection: By interrupting trading during periods of extreme volatility, circuit breakers aim to protect investors from potential rapid price movements that can occur due to panic-selling or market disruptions.

• Market Stability: Circuit breakers contribute to overall market stability by preventing wild price fluctuations and providing a controlled environment for market participants to make informed decisions.

The specific mechanics of circuit breakers can vary, but here are some common examples:

• Price-Based Circuit Breakers: These circuit breakers are triggered when a specific percentage decline in an index or individual stock prices occurs within a specified time frame. For example, if the price of an index falls by a certain percentage within a specified period, trading may be halted temporarily.

• Volatility-Based Circuit Breakers: These circuit breakers are triggered when there is an excessive level of market volatility. They are often calculated using formulas that consider historical volatility measures. If the volatility exceeds a certain threshold, trading may be paused.

• Time-Based Circuit Breakers: These circuit breakers impose a temporary trading halt during specific time intervals, such as the first few minutes or the last few minutes of the trading session. The purpose is to allow for a smooth opening or closing of the market, reducing potential disruptions.

It’s important to note that circuit breakers are intended to be a temporary measure to restore calm and stability to the market. Once the specified period of the trading halt elapses, trading typically resumes based on the normal rules and procedures of the stock exchange.