Sunday, October 26, 2008

Meltdown 101: Why the market has circuit breakers

Fresno Bee
10/24/08 first posted

As nest eggs shrink, some may wonder why the market doesn't just shut down and let investors cool off. On Friday, it did just that, albeit very briefly - "circuit breaker" rules halted selling during pre-market trading when the contracts known as stock futures sank below a certain point. What are these circuit breakers, and why do we have them? What would it take to get them to shut down normal stock trading?

Here's a list of questions and answers about how U.S. exchanges use circuit breakers to restrain wild market freefalls.

Q: What's a circuit breaker?

A: A circuit breaker is a rule set by a stock market that causes trading to automatically stop - at least temporarily - based on a dramatic shift in the value of the market.

Q: When were circuit breakers started, and why?

A: The New York Stock Exchange established circuit breakers in 1988 after the big stock market plunge in October 1987, and amended them in 1998. Circuit breakers force traders to take a breather, stop selling and refocus on economic and corporate news instead of an alarming market nosedive.

Q: The Dow Jones industrial average has shed about 40 percent of its value since its peak last October - why haven't circuit breakers kicked in?

A: It's all about how much stocks fall in a single day. Circuit breakers aren't in place to prevent people from losing money; they're aimed at keeping the market from succumbing to huge, snowballing, panic-driven sell-offs.

Q: How far do stocks have to drop in a day for trading to stop?

A: If the Dow Jones industrial average falls 1,100 points - equivalent to about a 10 percent drop from the Dow's level at the beginning of the quarter - before 2 p.m., the market shuts down for an hour. If it falls by that amount between 2 p.m. and 2:30 p.m., the halt lasts 30 minutes. But if stocks drop 1,100 points after 2:30 p.m., trading continues.

If the Dow falls 2,200 points - about 20 percent - before 1 p.m., the market closes for two hours. If such a decline occurs between 1 p.m. and 2 p.m., there is a one-hour pause. If stocks tumble 2,200 points after 2 p.m., the market closes for the day.

If the Dow sinks by 3,350 points - or about 30 percent from its level at the start of the quarter - the market closes for the day, no matter what time it is.

Q: What about in pre-market trading?

A: In pre-market trading, also known as overnight trading, traders buy and sell contracts called stock futures - basically, they're placing bets on what stocks will be worth during the upcoming trading day. Futures are controlled by the circuit breakers, or "price limits," of the Chicago Mercantile Exchange. This exchange instituted its price limits along with the NYSE in 1988, and amended them in 1998, too.

If futures for the Dow, Nasdaq, or Standard & Poor's 500 index fall 5 percent in pre-market trading, the sale of those futures is paused unless a trader comes in and buys, lifting the futures back above the threshold.

The last time this happened - before Friday - was May 2001. Back then, the maximum allowed limit for gains or losses in futures trading was 2.5 percent - but because traders kept hitting that limit, the Chicago Merc raised it to 5 percent.

The newer limit was hit Friday. In pre-market trading, all three major futures indexes fell by the maximum allowable amount, automatically freezing selling. Trading was essentially halted until the market's open, because no one came in to buy.

Q: When have circuit breakers been tripped during regular trading hours?

A: The only time was in 1997. Circuit breakers shut down the market after an economic crisis in Asia set off a wave of heavy selling.

Q: Are steep upward movements controlled?

A: Only in overnight trading, when regular markets are closed and it's hard to get out of a short sale - a bet that a stock will fall. Recently, on Sept. 19, the S&P futures hit their limit up after rising 5 percent in pre-market trading.

But once the market opens, there are no restrictions on upward movements. If investors want to send the Dow soaring 3,000 points in a single day, it would be just as welcome to the NYSE as it would be to the average American with a 401(k).

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