What is circuit breaker in the stock market?

This picture comes into our mind when we hear the word circuit breaker. Right?

Now you may be thinking that what the circuit breaker has to do with the stock market?

It has nothing. Today, I am going to explain you one of the important topic in the equity market.

There are so many innate nuances to the stock market, aren’t there?

A number of small and seemingly insignificant mechanisms are embedded into the stock market. Most people are not even aware of their existence, let alone their meaning.

As a potential trader or investor, however, it is very important to know everything that you can know about the stock market. Because only when you are completely informed, you can play the prices to your advantage.

That is where I come in.

Today, I’m going to tell you about circuit breakers.

MEANING OF CIRCUIT BREAKERS IN THE STOCK MARKET

Circuit filter or circuit breaker in the stock market is referred to the price band that sets the floor and the ceiling within which the price of a share can fluctuate on any specific day. A price band for a day depends on the previous day’s closing price.

Simply put, a circuit breaker or circuit filter signifies the maximum that a stock could rise or fall before trading in that specific stock is halted for a certain duration of time.

The purpose of circuit breakers or circuit filters is to control the stock markets at times when they make movements beyond reasonable limits.

Sounds simple enough, right?

Now, what could be the point of circuit breakers?

Any guesses?

Circuit breakers in the stock market restrict extreme price movement and resist price manipulation. They also protect investors from extreme volatility of the prices of shares traded in the stock market.Circuit breakers in share market can be imposed on specific shares or on particular markets.

Let me give you an example.

Suppose you are privy to a piece of bad news that leads you to doubt the future of a certain company or companies that you have invested in.

What would be the most logical course of action for any rational trader in such a situation?

Why, sell off the stock as soon as possible.

Now imagine if a lot of people react in this same way. It would strike off a domino effect in the stock market.

As more and more investors start dumping their stock, valuations and price often lose their inherent correlation.

This is where circuit breakers come in.

To avoid any unwarranted sell off, and in order to give the investors a chance to reconsider their decision, trading in the stock is halted for a certain period of time.

How does circuit breakers work in the stock market:

  1. CIRCUIT FILTERS IN INDIVIDUAL SHARES

In case of circuit filters in individual shares, the price bands may be 2%, 5%, 10% or 20% either ways, depending on the categories of shares trading in the stock market. Dynamic Price band of 10% is applicable on those shares on which derivative instruments are available.

Let me give you an example.

Suppose, on 22nd of October the closing price of XYZ company is Rs.1000. If the circuit filter for XYZ is 10%, then the price band for 23rd October would be Rs.900 (lower limit) to Rs.1100 (upper limit).

Let’s take a live example,

Example of how circuit breakers work in the stock market
Live example of circuit breaker in stock market

The previous day’s closing price of SBI is Rs.256. SBI comes under 10% circuit breaker price band. Hence, Lower price band of SBI is 10% lesser than the previous close and upper price band is 10% higher than the previous close. Therefore, lower price band of SBI is Rs. 256-(10% of 256) = 256-25.6=Rs.230.40 & upper price band is 256+(10% of 256) = 256+25.6 = Rs. 281.60

2. MARKET WIDE CIRCUIT BREAKERS

The market wide circuit breakers were introduced in India with effect from 2nd of July, 2001. They do the same job for the entire market what circuit filters associated with specific securities do. They bring about halt in all the markets in the country.

The market wide circuit breakers are imposed on three stages of index movements i.e. 10%, 15% and 20%. A 15 minutes pre- opening call auction session post some trading halts has been introduced by the SEBI.

Let me tell you the stock market circuit breaker rules to give you a better idea.

The chart given below shows the duration of the market halt and pre-open call auction session associated with market wide circuit breakers.

Index movement Time of movement Market halt duration Pre-open call auction session post trading halt
10% Before 1p.m. 45 minutes 15 minutes
10% After 1p.m but before 2.30 p.m. 15 minutes 15 minutes
10% On or after 2.30 p.m. No halt Not applicable
15% Before 1p.m. 1 hour and 45 minutes 15 minutes
15% After 1p.m. but before 2.00 p.m. 45 minutes 15 minutes
15% On or after 2.30 p.m. Halt for remainder of the day Not applicable
20% Any time of the day during trading hours Halt for remainder of the day Not applicable

Source: NSE

The percentages of index movements are not calculated on a daily basis. They are fixed for a quarter. These percentages are computed into absolute points of index variations on quarterly basis, based on closing index of last trading day of the previous quarter.

Let me give you an example.

Let’s assume that on any day, the index increases or decreases by 15% over the closing index of the previous day. This means that 15% circuit breaker is imposed.

upper circuit in shriram pistons & rings limited
upper circuit

Image source: bloomberg.com

CONCLUSION

Now that you know what circuit breakers are, their importance is self-explanatory, right?

Share prices can move both ways and therefore circuit breakers or circuit filters are needed for movements in both directions. An upside movement over the threshold will result in a share to enter an upper circuit. Similarly a downside movement in share price beyond the threshold will cause a share to enter a lower circuit. Instead of using the word “circuit breaker”, stock market commentators generally use the words upper circuit and lower circuit.

When a share makes an entry into an upper circuit, it results in putting an investor who has already invested in the share at an advantage. On the contrary, a share movement into a lower circuit leads to placing an investor at a disadvantage because it is now tough to dispose of these shares as he/she has lost a lot of money.

Circuit breakers thus help keep the fluctuations of the share prices within reasonable limits. Their importance is, therefore, tremendous in the ever fluctuating scenario of the stock market. If you would like to add something or express your opinions, feel free to leave a comment. Happy trading!



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