What is circuit breaker in trading and how does it work?
Investors and traders might have often seen a company’s share price move sharply in one direction and then after reaching a particular point, the price freezes and doesn’t move from that level. That’s when many might have heard the terms ‘upper circuit’ and ‘lower circuit’.
An upper circuit or lower circuit limit is known as a circuit breaker. This is a regulatory mechanism imposed by the stock exchanges. Under a circuit breaker mechanism, a range is decided within which the price can move. The price cannot go above or below this range.
This mechanism temporarily halts trading on an exchange. It is used to prevent panic selling in the market or manic buying that leads to extreme price volatility in the market. The circuit breakers get triggered automatically when prices hit predefined levels and halt trading on the bourses.
The capital markets regulator Securities and Exchange Board of India imposed the circuit breaker rule in India in 2001. SEBI formulated market-wide, index-based circuit breakers.
How do circuit breakers work?
Under the rules set by SEBI, circuits on the benchmark index are triggered at three levels of moving 10%, 15% or 20% in either direction. Nifty 50 and Sensex are the benchmark indices of India and trading in them gets suspended for a pre-defined period of time if these indices breach the circuit breaker limits.
As the market reopens after the halt, a 15-minute pre-open call auction session is conducted to determine the equilibrium price of a stock or index. This is based on demand and supply conditions.
Similarly, different stocks have different circuit breaker levels. This prevents the price of a stock from moving above or below a certain level. The circuit levels for stocks are calculated by the exchanges based on the previous day’s closing and can be set at 5%, 10% or 20%. However, stocks that have derivatives which are traded, do not have circuit breakers.
How do circuit breakers help?
Circuit breakers are helpful to prevent heavy losses and protect investors. By imposing a limit on how low a stock can go, it gives investors time to think and also prevents panic selling. It can also prevent mass accumulation of a stock which can significantly drive up the price of a stock and trap retail investors.
However, circuit breakers act as a hindrance to real-time price discovery and early information can be used by traders to benefit before a circuit breaker is implemented.
Disclaimer: Investment in securities market are subject to market risks. Read all the related documents carefully before investing. Please refer the Risk Disclosure Document issued by SEBI and go through the Rights and Obligations and Do’s and Dont’s issued by Stock Exchanges and Depositories before trading on the Stock Exchanges. Brokerage will not exceed the Exchange prescribed limit.
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