How stock market 'circuit breakers' cool trading panic

China suspended stock trading for the second time in a week on Thursday, after the CSI 300 market index plummeted seven per cent a half hour after markets opened.

The nosedive triggered what's called a "circuit breaker" in stock market vernacular, an automated procedure meant to temper volatile fluctuations in the index and panicked investor reaction by temporarily shutting down trading.

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Most major indexes, including the Toronto Stock Exchange, have similar circuit breakers. The New York Stock Exchange introduced its controls following the Black Monday crash of 1987.

Since April 2013, the Toronto and New York exchanges have co-ordinated their circuit breakers, with the length of regulatory halts divided into three levels.

Level 1 shuts down trading for 15 minutes if the index drops seven per cent; level 2 shuts down trading for 15 minutes if it drops by 13 per cent; and level 3 shuts down the entire trading day if the index falls by 20 per cent.

"[Circuit breakers are] a crude mechanism for stopping plunges and they are good at that," said Conor Bill, managing director of Mt. Auburn Capital.

Joseph D'Cruz, a professor at the Rotman School of Management, said circuit breakers "prevent short-term panic from spreading."

During the temporary trading hiatus, investors can take the time needed to make important decisions.

D'Cruz calls the stoppage a "cooling-off period."

"The moment circuit breakers take place, investors and traders can carefully reassess the situation and decide what they need to do," he said, adding that circuit breakers kicked in across many major stock exchanges during the 2008 financial crisis.

Without them, D'Cruz said, "a panic sell-off could take place," which could amplify the problem. 

Bill said that although circuit breakers can work, "nothing can be expected to eliminate gross human error."

China's circuit breakers on override

In China, circuit breakers hold off trading for 15 minutes after a five per cent index drop, and trading is halted for the day if the drop dips to seven per cent.

Before Thursday's shutdown, trading had been halted when circuit breakers kicked in Monday.

China's shutdown failed to calm the markets, however, and caused the Dow Jones, TSX and indexes in Europe to slump.

China has put a circuit breaker on its circuit breaker rule, suspending the mechanism starting Friday.

"The negative effect of the mechanism outweighed its positive effect," said Deng Ge, a spokesman for the China Securities Regulatory Commission in a statement.