Circuit breakers and their role in cooling volatility

Indian markets witnessed their second circuit breaker in a month on Monday as the benchmark Sensex tanked 10 per cent within the first hour of trading. Before the recent instances, circuit breakers were triggered at the peak of the previous global financial crisis.

This is second time since January 21, 2008 and sixth time in the past two decades that trading in India has been frozen because of indices hitting the lower circuit. Here are some of the most important things investors should know about a circuit breaker

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What is a circuit breaker?

It is a trading curb imposed by stock exchanges whenever there is heightened volatility. Circuit breakers became important tools for exchanges and global market regulators to cool-off since the 1987 Wall Street crash. Whenever a stock hits the circuit breaker, trading is shut down for some time in that counter. Then there are index circuit breakers that get triggered if benchmark indices rise or fall significantly. When the benchmark index hits the circuit breaker, trading is halted for a fixed time across the market. This time is called the cooling-off period and it is aimed at calming the panic in the market.

Are circuit breakers always signs of bad news?

A circuit filter can be triggered even if a stock or an index is gaining too much, too quickly. For instance, in 2009 Indian markets witnessed circuit breakers due to a sharp rally of over 10 per cent in a single session.

When is a circuit breaker triggered?

In the Indian markets, there are three different circuit breakers that get triggered.

The first one is when the index rises or falls 10 per cent from its previous close.

The second one is triggered at 15 per cent rise or fall, while the third one is activated at 20 per cent rise or fall. The mandatory cooling of period varies, depending on which circuit filter has been hit. It could be as low as 15 minutes if the 10 per cent circuit is triggered. On the other hand if the market hits say the 20 per cent circuit, trading will be halted for the rest of the session.

Which are the other factors that impact the cooling-off period?

Apart from which circuit has been triggered, the quantum of the cooling off period applicable also depends on at what time the circuit was triggered.

If the market breaks the 10 per cent circuit before 1 pm during any session, trading will be halted for 45 minutes, like what was witnessed on Monday.

If the same circuit is hit between 1 pm and 2:30 pm, the halt will only be for 15 minutes and if is triggered after 2:30 pm, there will be no halt in trading.

The cooling off-period increases as we go to higher circuits. If a 15 per cent circuit is hit in a session before 1 pm, the trading is halted for 105 minutes while the cooling-off will only be 45 minutes in case the same is triggered between 1 pm and 2:30 pm.

If the 15 per cent circuit is hit any time after that, markets are closed for the rest of the session. Whenever the market hits the 20 per cent circuit, trading gets automatically closed for the rest of the session.

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