What is a circuit breaker?
- A “circuit breaker” is a system that limits the risk of buying and selling within a stock market.
- When the market price of the particular commodity or currency increases or decreases more than expected, a circuit breaker kicks in, which momentarily stops all trading.
- Circuit breakers are used in economies around the world to avoid market crashes.
Understanding the term “circuit breaker.”
To understand what a circuit breaker determines in the financial world, let’s discuss first how a circuit breaker works in our day-to-day lives. When a particular appliance or electronic device consumes more power than it should, it will overheat and sometimes the circuits explode, thus the term “short circuit.” A circuit breaker prevents such a scenario by temporarily shutting down the source of electricity. Shutting off the electric supply happens for safety reasons, to prevent tragedies like fire and physical injuries.
In the financial world, a circuit breaker regulates the financial health of a stock exchange. It appears in the form of percentages. For example, when the price of an influential index like the Standard and Poor’s 500 (S&P 500) increases by 7% within ten hours, the circuit breaker halts trade for a while so that traders can decide whether they want to buy or sell their stocks.
Demonstrating how circuit breakers work should make this concept easier. For instance, let’s say the price of the S&P 500 index is $50. Only 10% (which is $5) is allowed to move for trades to be submitted and processed. If the price goes up or goes down by $5, the trade temporarily halts. Traders will continue once the pause is over. The time of pausing during a circuit break varies according to the rules and regulations around the commodity or asset.
The emotional factor
Temporarily halting stock trading can really help investors regain their trust or give traders time to take a breath before acting. Even if the stock market is filled with numbers and graphs, traders’ actions are more likely based on their emotions. The emotional factor of trading significantly affects the fluctuation rates. When the price goes down, traders may jump on the bandwagon and sell their stocks. This situation is called “panic-selling.” Investors want to grab this opportunity to exit early, avoiding significant losses on their investments.
Learning from mistakes
The most notable financial disaster is Black Monday. The sudden dive of prices gave regulators the idea to use a “price break,” which is more known today as a circuit breaker. The circuit breaker was then born out of the tragedy of Black Monday.
On October 19, 1987, the Dow Jones Industrial Average (DJIA) took a nosedive of about 22% in one day. This event caused a significant decline in the global stock market. Another major disaster was the Flash Crash of 2010 when the stock market plummeted within minutes. The previous incident gave birth to the circuit breaker while the latter urged the development of security from the risks of technological advancement.
The future of circuit breakers
With cryptocurrencies becoming more popular today, talks about creating circuit breakers in major digital exchanges have begun to surface. High volatility is observable in significant cryptocurrencies like Bitcoin. The price rose up from $0.01 in 2010 to almost $20,000 in 2017. The so-called “crypto-boom” lured people who are not well-versed in the financial world. Some earned billions while others suffered significant losses after selling or mortgaging properties in favor of buying cryptocurrencies.
Market prices are fundamentally dictated by supply and demand forces. Every time the invisible hand of the market lifts somebody up, someone else goes down. Circuit breakers are set in place to protect every participant in the stock exchange market, thus making these circuit breaks necessary for the entire world economy.