In Finance, what is a Circuit Breaker?

Circuit breakers are strategies or measures that are employed by a stock exchange when there is a need to avert a sense that something catastrophic is about to happen. Sometimes referred to as a collar, the purpose of the circuit breaker is to prevent a panic situation that results in a lot of investors dumping an extreme amount of securities because there is a feeling of an impending crash or significant depression in the market. Essentially, the circuit breaker helps to form a stopgap that keeps a stock exchange on a more even keel until a more reasonable mindset prevails among the traders.

The most common configuration for a circuit breaker is to initiate a carefully crafted series of trading halts with a sprinkling of price limits. Generally, the price limits are focused on derivative markets and equities. By creating this temporary status of slowing down, there is a better chance for the commodity exchange process to continue within healthy levels, and not run out of control.

As a strategy to correct a temporary situation within a securities market, the circuit breaker is a relatively new approach. It was only after the minor stock market crash of 1987 that the concept of a circuit breaker was developed. A series of procedures was developed and agreed upon by the main stock and commodities exchange markets around the world.

These procedures would essentially involve taking specific actions to slow down market activity when falls in prices hit certain percentage levels. Various markets have provisions to employ the circuit breaker approach when falls hit levels of ten, twenty, or thirty percent. The drop is usually based on monitoring the activity on the Dow Jones Industrial Average. When a rapid drop hits ten percent, it is likely that a circuit breaker approach will be implemented by at least some of the major markets. However, to date the strategy has only been employed once, on 27 October 1997.