What is a Circuit Breaker in Trading and How Does it Work?

Volatility is an integral part of the financial markets. It is a measure of the amount of variation or fluctuation in the price of an asset over time. The higher the volatility, the greater and more unpredictable the price movements are likely to be. 

However, stocks that experience high volatility are often susceptible to adverse effects that can even lead to panic in the market if not managed properly. To mitigate such risks, the Securities and Exchange Board of India (SEBI) has implemented a mechanism known as the circuit breaker. 

As a trader, you need to know what a circuit breaker in the stock market is and how it works since this safety mechanism has the potential to severely impact trading. Continue reading to find out all about circuit breakers and just how important they are. 

What is a Circuit Breaker in the Share Market? 

If you have ever traded or monitored the stock market, you might have noticed certain stocks moving significantly upward or downward after they open for trading. However, beyond a certain point, the price movement would stop completely as if the trading had suddenly come to a halt. This particular phenomenon in the market is due to the circuit breaker mechanism. 

A circuit breaker is a regulatory mechanism that stock exchanges implement to manage excessive volatility in the market. The system automatically halts all trading activities if predetermined thresholds of price movement are breached. The primary goal of a circuit breaker is to act as a safeguard to market integrity by preventing panic-driven selling or buying.

What are Upper Circuit and Lower Circuit Limits?

Before exploring how circuit breakers work, it's essential to first understand the concepts of upper circuit limit and lower circuit limit. 

The upper circuit limit refers to the maximum permissible upward price movement in a stock or index in a trading session. The lower circuit limit, meanwhile, refers to the maximum permissible downward price movement in a stock or index in a trading session. 

Upper circuits restrict excessive price surges, whereas lower circuits prevent steep declines. When a stock or an index hits either the upper or lower circuit limit, trading is temporarily suspended to maintain stability and prevent extreme price fluctuations. 

How Does a Circuit Breaker Work?

Now that you are aware of what a circuit breaker in the stock market is, let us delve deeper into the mechanism to understand it better. 

Let’s take a hypothetical scenario involving the stock of XYZ Limited. The stock is listed on the National Stock Exchange (NSE). The previous day’s closing price of the stock was Rs. 2,500. The exchange has set the upper and lower circuit breaker limit at 10% of the previous day’s closing price. 

This essentially means that the upper circuit limit for XYZ Limited on the next trading day would be Rs. 2,750 [Rs. 2,500 + (Rs. 2,500 * 10%)]. Meanwhile, the lower circuit limit for XYZ Limited would be Rs. 2,250 [Rs. 2,500 - (Rs. 2,500 * 10%)].

Now, if the stock either rises beyond the upper limit of Rs. 2,750 or falls below the lower limit of Rs. 2,250 due to increased volatility, the circuit breaker mechanism will kick in and halt trading on the stock temporarily. 

The pause in trading not only prevents irrational trading decisions driven by panic or euphoria but also provides market participants the time to reassess their positions and adjust strategies accordingly.

Conclusion

The circuit breaker in the stock market is a very useful mechanism that acts as a safety net against excessive volatility. From mitigating risks and stabilising markets to protecting investors and preventing price manipulations, the mechanism provides a plethora of advantages. 

Trading in stocks and other financial instruments in a volatile trading environment can be both highly risky and rewarding. With the right tools at your disposal, such as the ones offered by the Research 360 platform of Motilal Oswal, you can ensure that you capitalise on the various trading opportunities that volatile market scenarios offer. 

Sign up for Research 360 today to get access to the plethora of powerful features designed to help you become a better trader. After a brief pause, the trading in the stock is resumed once again by the exchanges often with certain restrictions such as with position sizes to curb volatility. If there are no further spikes in volatility, trading carries on normally for the rest of the session. However, if excessive volatility still persists even after the brief pause, the circuit breakers will kick in and stop trading once again. 

What are the Circuit Limits for Stocks and Market Indices? 

The upper and lower circuit limits for a stock are determined based on the closing price of the previous trading day and will vary from one stock to another. According to the Securities and Exchange Board of India (SEBI), the circuit levels for stocks are as follows. 

Note: There is also another group, namely Group F, which comprises fixed-income and debt securities. These securities often have much higher circuit limits compared to the equity segment. 

You can find information regarding the circuit limits for any particular stock or financial instrument on the website of the stock exchanges. Alternatively, you can also find them on the trading platforms of stockbrokers. 

In the case of market-wide indices like Nifty 50 and Sensex, there are three circuit limits at 10%, 15% and 20% of the previous day’s closing price. The duration of the market halt is dependent on the time of day at which these circuit limits are triggered. It could range from 15 minutes to the rest of the trading day depending on the severity of the breach.