Trading in Indian stock markets was halted for 45 minutes for a second time in 10 days as the BSE Sensex plunged to more than 10 per cent in opening trade on Monday. The trading was halted after the Sensex hit lower circuit as soon as trading began on Monday.
But, what is a circuit breaker? Why is it used? Here’s all you need to know:
What are circuit filters or circuit breakers?
A circuit filter or circuit breaker is the band of upper and lower limits within which a benchmark market index can fluctuate on a particular day. These are regulatory mechanisms put in place in stock markets to temporarily halt trading on an exchange to curb panic-selling. Circuit breakers are a form of market curbs.
The index cannot fall below the lower limit or climb above the upper limit. These limits are based on the previous day's closing price. Circuit limits are just for indices; stocks have price bands, which act in the same way.
These filters restrict extreme price movement and curb price manipulation to a certain extent by stock operators. The filters also protect investors from extreme price fluctuations.
Circuit breakers were set in after the Back Monday crash of 1987 in US stock markets.
What are the circuit limits of the Indian stock markets?
For Indian stock exchanges, the circuit limits are set by the Securities and Exchanges Board of India (SEBI). The market-wide circuit breaker system of the BSE and NSE applies at three stages of the index movement, ie, the stock trading is halted if the index zooms or falls 10 per cent, 15 per cent and 20 per cent. These circuit breakers bring about a coordinated trading halt in all equity and equity derivative markets nationwide.
A market-wide circuit breaker is applied in the Indian stock markets if either the BSE Sensex or the Nifty 50 breaches the limits.
When a stock hits an upper circuit, there will be only buyers and no sellers. Similarly, when a stock hits a lower circuit, there will be only sellers and no buyers. Circuit breakers differ across the markets worldwide. For instance, the circuit breakers are activated in US markets when the S&P 500 index hits 7 per cent, 13 per cent and 20 per cent in intraday moves.
Trigger limits and duration in Indian stock markets
10 per cent fall or rise before 1pm—trading halt of 45 minutes
10 per cent fall or rise between 1 pm and 2:30 pm—trading halt of 15 minutes
10 per cent fall or rise after 2:30 pm—no halt
15 per cent movement before 1pm—trading halt of 1 hour 45 minutes
15 per cent movement between 1 pm and 2:30pm—trading halted for 45 minutes
15 per cent movement after 2:30pm—trading is halted for the remainder of the day
20 per cent movement any time of the day—trading halt for the remainder of the day
What happens when the market reopens after a circuit breaker?
The market re-opens, after index based market-wide circuit filter breach, with a pre-open call auction session of 15 minutes post the duration of halt. The normal trading could begin and continue as long as the next circuit limit does not activate.
Why circuit breakers?
Stocks and indices move on the basis of buy and sell trades in the market. However, in the event of news—either negative or positive—the stock or index can move by a great amount. This, however, increases volatility in the market, and may put retail investors at a disadvantage. This is because retail investors are almost always the last to react to news and sell or buy a stock.
The circuit levels are determined by the stock exchanges so as to protect investors and brokers from an unwanted surprise moment. In case of a sudden swing investors tend to lose a massive chunk of their capital. Even traders may have to face margin calls from their brokers in case market plunges or surges too much.
Circuit filters or breakers also help limit speculative trading, which could result in big losses. The upper limit is to ensure that a stock does not rise indefinitely. Otherwise, short sellers—those who borrow stocks to sell in anticipation of a fall in prices, and later buy back at the end of the market session—do not face severe losses. Even long-term investors benefit from such limits. For instance, say, you bought a stock at Rs 100 five years back. The stock might be trading at Rs 500 in the current market price. If it falls back to Rs 100-levels in the course of one single day, it would result in a heavy for the investor. A circuit limit avoids such drastic crashes.