Beginner’s Guide to Market Volatility

How a rarely used market protection helps investors when stocks drop sharply

Twenty/20

Twice this week, sharp declines in the U.S. stock market have triggered an unusual protective measure known as a circuit breaker, or a brief pause in trading

The first happened Monday, when the market started the week with its steepest decline in years following a major decline in the oil market over the weekend, along with mounting fears over the continued spread of the novel coronavirus. At 9:34 a.m., just four minutes after the opening bell, all trading stopped on the New York Stock Exchange, and traders had to wait 15 minutes to start again.

A circuit breaker was triggered again Thursday morning, a day after the World Health Organization declared that COVID-19 is now a pandemic and President Trump announced a 30-day ban on travel from most of Europe. This time, the market was open for five minutes before trading halted at 9:35 a.m.

While a circuit breaker is fairly uncommon, it won't have a huge effect on long-term investors. If anything, this protective measure can ensure that a selling frenzy doesn't occur and potentially limit the severity of a one-day market decline. And they could help to temper some of the market headlines that might lead you to make moves out of fear.

Here's what you need to know about how circuit breakers work and their effect on the market.

VIDEO2:1702:17
Why you shouldn't panic when markets are bumpy

Video by Stephen Parkhurst

Circuit breakers are a 'time out' for the market

Much of what goes on in the stock market happens based on traders' perceptions at any given moment. If too many traders sell too rapidly, the sense that the markets are trending downward will spread across the trading floor, triggering more frenzied selling. 

A circuit breaker stops that frenzy, giving traders 15 minutes to assess the state of the market. Its goal is to remove some of the pressure to react hastily.

"It is an opportunity for the market and investors to take a breath," says Mark La Spisa, a certified financial planner and the president of Vermillion Financial Advisors in South Barrington, Illinois. "The market plays off momentum, and momentum can be a crazy thing at times. So in times of extremes, it takes a time out."

This sentiment was echoed by Stacey Cunningham, president of the NYSE, in a tweet Monday.

Different percentage drops trigger different reactions

The circuit breaker has three levels to stabilize market declines of varying severity. The current system, which went into effect in 2013, was triggered for the first time Monday morning. They're effective for both the NYSE and Nasdaq. 

Here's what it takes to trigger different levels of circuit breakers: 

  1. If the S&P 500 declines 7%, trading will pause for 15 minutes. This is what happened on Monday, and again on Thursday.
  2. If the S&P 500 declines 13%, trading will again pause for another 15 minutes, as long as the decline occurs on or before 3:25 p.m. If the decline happens after that, trading continues normally until the markets close at 4 p.m.
  3. If the S&P 500 falls 20%, the markets close for the rest of the day.
[A circuit breaker] is an opportunity for the market and investors to take a breath.
Mark La Spisa
President of Vermillion Financial Advisors

The Securities and Exchange Commission first introduced circuit breakers after the "Black Monday" crash of 1987, when the Dow plummeted nearly 23%, which still stands out as this index's largest single-day percentage decline.

Previous systems were set up to trigger circuit breakers after the Dow dropped by a specific number of points. Today's system is based entirely on percentage drops in the S&P 500. The SEC adopted the current, modified system after the previous one failed to stop the 2010 "flash crash."

Steven Rich, database editor for investigations at The Washington Post, tweeted Monday about the value of that change in ensuring that the circuit breaker goes off at the right time.

The NYSE has closed early only once because of the circuit breaker. That was in 1997, when the Dow dropped 554 points, or 7%, in a single day during the Asian financial crisis. 

The latest circuit breaker worked 'as it's supposed to'

Once trading resumed at 9:49 a.m. Monday, the S&P 500 stabilized within minutes. Through midafternoon, it remained down 6.6% for the day. While not insignificant, that drop wasn't in danger of triggering a second circuit breaker.

It remains to be seen how the circuit breaker will affect the market on Thursday. Shortly after trading resumed, stocks extended their losses, with the S&P 500 briefly down 8%. 

"This is operating as it's supposed to," NYSE's Cunningham told CNBC's Bob Pisani on Monday.

While market turbulence can be nerve-wracking, La Spisa maintains that the usual rules still apply for long-term investors: Avoid panicked selling, and take advantage of cheaper stock prices. Young investors in particular stand to gain from staying the course.  

"Looking back, this will be in the rearview mirror by the time they go into retirement," says La Spisa. "Just like people that are retiring today don't even think about 1987."

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