It’s hard to predict when a stock market crash will occur, so the best defense is to be prepared.
The Very High Risk Of Low Volatility
Today’s infographic comes to us from StocksToTrade.com, and it explains what happens when a large enough drop in the market triggers a “circuit breaker”, or a temporary halt in trading.
At this year's SALT New York conference, Wences Casares, the chairman of XAPO, and Peter Briger, the principal and co-chief executive officer of Fortress Investment Group discussed the macro case for Bitcoin. Q2 2021 hedge fund letters, conferences and more XAPO describes itself as the first digital bank of its kind, which offers the "convenience" Read More
These temporary halts in trading, or “circuit breakers”, are measures approved by the SEC to calm down markets in the event of extreme volatility. The rules apply to NYSE, Nasdaq, and OTC markets, and were put in place following the events of Black Monday in 1987.
Circuit Breaker Rules
Previously, the Dow Jones Industrial Average (DJIA) was the bellwether for such market interventions.
However, the most recent rules apply to the whole market when a precipitous drop in the S&P 500 occurs:
|Before Feb 2013||After Feb 2013|
|Index Tracked||DJIA||S&P 500|
|Level 1 Threshold||-10%||-7%|
|Level 2 Threshold||-20%||-13%|
|Level 3 Threshold||-30%||-20%|
Upon reaching each of the two first thresholds, a 15-minute halt in trading is prompted. This is the case unless the drop happens in the last 35 minutes of trading.
Upon reaching the third threshold (-20% drop in S&P 500), the day’s trading is stopped altogether.
Can Circuit Breakers Stop a Market Crash?
In theory, the use of circuit breakers can help curb panic-selling, as well as limit opportunities for massive gains (or losses) within a short time frame. Further, by creating a window where trading is paused, circuit breakers help make time for market makers and institutional traders to make rational decisions.
Regulators and exchanges hope that all of this together will give investors a chance to calm down, preventing the next market crash.
But do circuit breakers actually work? While they make logical sense, recent evidence from China paints a murkier picture.
The Illusion of Safety
In Paul Kedrosky’s piece from The New Yorker, titled The Dubious Logic of Stock Market Circuit Breakers, he makes some interesting points on the series of market crashes in China from late-2015 to early-2016.
To understand why circuit breakers can make markets less ‘safe,’ imagine that you’re a Chinese trader on a day when markets are approaching a five-per-cent decline. What do you do? – Paul Kedrosky, The New Yorker
Kedrosky continues by explaining that a market participant in that situation would try to get as many sell orders in as possible, before the circuit breaker is triggered.
Further, when the markets re-open, the same trader would again sell immediately to avoid the second breaker (which triggers an end in trading for the day). Each time the breakers get triggered, it creates a market memory of the events, and traders try to avoid future shutdowns by selling faster.
Preparation is Key
Whether they work or not, it is essential for investors to understand the rules behind circuit breakers, as well as how markets think and react after these pauses in action.
In the event of a market crash, this preparation could help to make a difference.
Article by Jeff Desjardins, Visual Capitalist