The strange attraction of circuit breakers

Circuit breakers that stop trading in individual stocks or the entire market if prices drop too fast have been widely introduced after the 1987 stock market crash. Circuit breakers get triggered frequently during financial crises, of which we obviously had quite a few in the last three decades. In general, they are a blessing because they allow traders to calm down and assess the situation without having to make snap judgements in a panicky situation.

Hui Chen and others looked at what happens when share prices come closer to the level at which the circuit breaker will be triggered and found that circuit breakers act like a magnet or a strange attractor. As share prices drop, price volatility increases which is normal market behaviour. However, the chart on the top left shows that the skewness of the share price distribution becomes increasingly negative as prices approach the circuit breaker. This means that as share prices come closer to the circuit breaker, they are becoming more and more likely to swing to lower prices, accelerating their decline and making it more likely that the circuit breaker will be triggered.

It seems as if traders subconsciously start to push share prices towards the circuit breaker level to get that pause, they need in order to calm the market down and no longer be forced to settle trades at increasingly irrational prices. We may not be doing this consciously or voluntarily (in the heat of the moment, there is hardly any time to do that voluntarily), but when we panic, we tend to look for a safe place to hide and the circuit breaker provides just that. The result is that ironically, circuit breakers are likely to be triggered more often after they have been introduced at a stock exchange than before they would have been before.

Share price behaviour as they approach a circuit breaker

Source: Chen et al. (2023). Note: DTCB = Distance to circuit breaker