In recent weeks we have seen a continuous selloff in the stock market, triggered by real economic fears caused by the global Coronavirus (COVID-19) outbreak. Over the decades, certain safeguards have been put into place by stock exchanges, specifically for situations like this. The reason these safeguards were put into place was not to attempt to stop major market selloffs, but to provide some type of management to the downfall.
Circuit breakers are one of these safeguards that have been put into place to halt the market during a market selloff, which are triggered at certain levels of the selloff. There were also other regulations put into place over the years to help slow down a market fall out based on other criteria. Recently these mechanisms have been put to the test.
(Source: Bank of America Global Investment Strategy, Bloomberg)
I was a Runner on the floor of a stock exchange options trading floor in 1987. In 1987, the Short Sale rule was slightly different in that there were no circuit breakers in place and Short Selling was always prohibited in general, at prices which were equal to or lower than the last sale of a stock if the last sale was a downtick or zero minus tick. Regardless of which Short Sale rule was in place in 1987, options traders, in particular, were faced with a unique difficulty.
"In 1987, an options trader was forced by obligation to sell Puts and buy Calls by taking the other side of the incoming options orders, however, that same trader was unable to Short stock in order to neutralize delta because there wasn’t a plus tick in the market to be had."
On October 19th, 1987, the orders going into options exchanges were predominantly orders to Buy Puts and Sell Calls. With the Short Sale rule at the time, options traders were stuck with the obligation of providing liquidity for the orders going into the market but quickly found it almost impossible to hedge. For example, an options trader was forced by obligation to sell Puts and Buy Calls by taking the other side of the incoming options orders, however, that same trader was unable to Short stock in order to neutralize delta because there wasn’t a plus tick in the market to be had. The ultimate result for many traders were losses across the board.
After the 1987 event, regulators required that mechanisms be put into place to help slow down a market fallout. Exchanges then implemented circuit breakers that impose trading halts for the entire market overall, as well as for individual stocks. In addition, other regulations were put into place such as Limit Up / Limit Down, which was implemented as a result of the Flash Crash of May 6th, 2010, which imposes trading pauses when certain conditions exist in the markets, and also Reg SHO, which imposes short sale restrictions on individual stocks that fall 10% below the previous day’s closing price.
Now let's look at how the market is behaving under the current extreme volatility with the price volatility circuit breakers in place. On March 16th, we saw 814 volatility trading pauses on Nasdaq triggered across 554 different stocks. The S&P Index circuit breaker was also triggered three times during the day. These pauses have certainly slowed the downfall so that the selloff impact is lower than observed in 1987 on Black Monday. This temporary reprieve has provided invaluable time for the Federal Government to devise and release stimulus for the economy.
Some countries have mirrored the US system such as Thailand which has circuit breakers in place that trigger halts when there are drops in the market at 8%,15% and finally 20%. In Indonesia, the stock exchange added a trigger halt mark of 5% to one that already existed at 10%. Contraversely, the Philippines exchange imposed a three day cease in trading closing the market entirely. The impact was an intense selloff when trading resumed resulting in a larger impact.
What we can see is that the circuit breakers are a temporary measure to slow a market selloff and provide some short term relief to market participants. Some traders argue however that these mechanisms at times can have the opposite impact with the more sophisticated traders predicting and trading ahead of market halts which simply exacerbates the volatility.