Trading curb

A trading curb, sometimes referred to as a circuit breaker is a financial regulatory instrument that is in place to prevent stock market crashes from occurring. Since their inception, circuit breakers have been modified to prevent both speculative gains and dramatic losses within a small time frame. As a result of being triggered, circuit breakers either stop trading for a small amount of time or close trading early in order to allow accurate information to flow amongst market makers and for institutional traders to assess their positions and make rational decisions.

United States

Description

On the New York Stock Exchange (NYSE), one type of trading curb is referred to as a "circuit breaker". These limits were put in place after Black Monday in 1987 in order to reduce market volatility and massive panic sell-offs, giving traders time to reconsider their transactions. The regulatory filing that makes circuit breakers mandatory on United States stock exchanges is Securities and Exchange Commission Rule 80B. [1] It is there that the specifics of circuit breakers are elaborated and the various price limits are outlined for investors to see.

The most recently updated amendment of rule 80B went into effect on April 8, 2013, and has three tiers of thresholds that have different protocols for halting trading and closing the markets.

At the start of each day, the NYSE sets three circuit breaker levels at levels of 7% (Level 1), 13% (Level 2) and 20% (Level 3). These thresholds are the percentage drops in value that the S&P 500 Index would have to suffer in order for a trading halt to occur. Base price levels for which these thresholds will be applied are calculated daily based on the preceding trading day’s closing value of the S&P 500. Depending on the point drop that happens and the time of day when it happens, different actions occur automatically: Level 1 and Level 2 declines result in a 15-minute trading halt unless they occur after 3:25pm, when no trading halts apply. A Level 3 decline results in trading being suspended for the remainder of the day. [1]

Circuit breakers are also in effect on the Chicago Mercantile Exchange (CME) and all subsidiary exchanges where the same thresholds that the NYSE has are applied to equity index futures trading. However, there is a CME specific price limit that prevents 5% increases and decreases in price during after hours trading. [2] Base prices for which the percentage thresholds are applied are derived from the weighted average price on the future during the preceding trading day's last thirty seconds of trading. Price limits for equity index and foreign exchange futures are posted on the CME website at the close of each trading session. [3]

There is a security specific circuit breaker system, similar to the market wide system, that is known as the "Limit Up - Limit Down Plan" (LULD). This LULD system succeeds the previous system which only prevented dramatic losses, but not speculative gains, in a short amount of time. This rule is in place to combat security specific volatility as opposed to market wide volatility. The thresholds for a trading halt on an individual security are as follows. Each percentage change in value has to occur within a 5-minute window in order for a trading halt to be enacted:

  • 10% change in value of any security that is included in the S&P 500 index, the Russell 1000 index, and the Invesco PowerShares QQQ ETF.
  • 30% change in value of any security that has a price equal to or greater than $1
  • 50% change in value of any security that has a price less than $1

The previous trading day’s closing price is used to determine which price range a specific security falls into. [4]

Founding

Following the stock market crash on October 19, 1987, the United States President Ronald Reagan assembled a Task Force on Market Mechanisms, known as the Brady Commission, to investigate the causes of the crash. The Brady Commission’s report had four main findings, one of which stated that whatever regulatory agency was chosen to monitor equity markets should be responsible for designing and implementing price limit systems known as circuit breakers. The original intent of circuit breakers was not to prevent dramatic but fair price swings, rather to allow time for sufficient communication between traders and specialists. In the days leading up to the crash, price swings were dramatic but not crisis-like. However, on Black Monday the crash was caused by lack of information flow through the markets among other discrepancies such as lack of uniform margin trading rules across different markets. [5]

Instances of use

On October 27, 1997, under different trading curb rules then in effect, trading at the New York Stock Exchange was halted early after the Dow Jones Industrial Average declined by 550 points. [6] [7] This is the only time US stock markets have closed early due to trading curbs. Since then, circuit breakers have evolved from a Dow Jones Industrial Average points-based system into a percentage change system that tracks the S&P 500.

Then SEC Chairman Arthur Levitt Jr. believes this instance of use was unnecessary, [8] and that market price levels had increased so much since circuit breakers were implemented that the point based system triggered a halt for a decline that was not considered a crisis. [9] Some, like Robert R. Glauber, suggested in the aftermath of the circuit breaker tripping that trigger points be increased, and automatically reset by formula on an annual basis. [8]

Program trading curbs

The NYSE formerly implemented a curb on program trading under certain conditions. A program trade is defined by the NYSE as a basket of stocks from the S&P 500 where there are at least 15 stocks or where the value of the basket is at least $1 million. Such trades are generally automated.

When activated, the curbs restricted program trades to sell on upticks and buy only on downticks.

The trading curbs would become activated whenever the NYSE Composite Index moved 190 points or the Dow Jones Industrial Average moved 2% from its previous close. They remained in place for the rest of the trading day or until the NYSE Composite Index moved to within 90 points or the Dow moved within 1% of the previous close.

Since over 50% of all trades on the NYSE are program trades, this curb was supposed to limit volatility by mitigating the ability of automated trades to drive stock prices down via positive feedback.

This curb was fairly common, and financial television networks such as CNBC often referred to it with the term "curbs in".

On November 7, 2007, the NYSE confirmed that the exchange has scrapped this rule from November 2. [10] The reason given for the rule's elimination was its ineffectiveness in its purpose of curbing market volatility since it was enacted in the wake of the 1987 stock market crash under the belief that it may help prevent another catastrophic market crash.