Circuit Breaker in Stock Market: Meaning, Benefits & Risks

Stock markets are highly volatile in nature due to various   factors. Investors and traders try to use this volatility to their advantage and earn profits. However, sometimes a sharp and abrupt rise or fall in the price of securities can lead to severe losses. 

To protect market participants from such extreme forms of volatility, SEBI, India’s capital markets regulator, introduced the circuit breaker concept in the stock market. . This mechanism leads to a temporary pause in trading for a specific duration, depending on the time it became operational. Let’s discuss the most important aspects of this concept in detail. 

What Are Circuit Breakers and How Do they Work?

This concept came into existence in 1987 as a result of a huge US stock market crash that happened on 19 October 1987. In the world of stock trading, this phenomenon is known as Black Monday, which had severe sell-off repercussions across the global markets. Circuit breakers were used to curb panic selling on stock exchanges. 

On July 2,  2021, SEBI introduced the concept of an index-based market-wide circuit breaker rule to curb extreme fluctuations in India’s stock markets. 

Stock exchanges can apply circuit breakers during three stages of the price movement of a particular index. It includes a rise or fall in index value by 10%, 15% and 20%. Application of these circuit breakers leads to a coordinated pause in the trading of equity and related instruments. 

Now that you are aware of the meaning of circuit breakers in share markets, let’s move our attention towards other aspects of the same.   

What Is the Duration of Circuit Breakers?

In the stock market, a circuit breaker works the same way as electrical circuits. When things get out of hand, i.e., there are extreme fluctuations in prices, it gets triggered and shuts down the trading session. 

Once an index hits the trigger limit during a particular moment of a trading session, circuit breaker will get activated for a pre-determined amount of time. Here’s a table for better understanding: 

Thus, we can see that if an index witnesses a rise or fall in its value by 10%, 15% or 20% during specific times of the day, trading session will get halted for a specific duration. 

What Are the Advantages of Circuit Breakers in Stock Markets?

Here are some advantages of using circuit breakers in share markets: 

• Opportunity for Reviewing Investments

A temporary halt in trading activities provides a  opportunity amidst the chaos to slow down and postpone any decision till the market stabilises. Investors can go through news and reports and alter their investments accordingly. 

• Prevent Stock Market Crash

The biggest objective of introducing this mechanism was to prevent panic selling and manic buying and subsequently prevent stock markets crash. After the Black Monday rout of global markets in 1987, several market regulators went into a huddle to find a way to stop such events in future. Since then, circuit breakers have mitigated any large scale market crash.

What Are the Disadvantages of Circuit Breakers?

Some disadvantages of circuit breakers are as follows:  

• Prevents Real-time Price Discovery 

Stock markets function on the principle of organic settling of prices. This means that market forces of demand and supply shall determine the prices. However, external influences like stopping trading abruptly will prevent organic price discovery. 

• Information Asymmetry 

Some market participants can get hold of the news of circuit breakers setting in earlier than others. This will offer them an unfair advantage as they would move first and adjust their positions so as to mitigate losses or even book profits. 

Final Word 

A circuit breaker in stock markets is a regulatory measure to stabilise markets and indices and resume fair trading sessions. It is effective to keep a check on the volatility in the stock market; as soon as a particular limit is crossed, trading is stopped for some time, which avoids further deterioration.  

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