What it Means That the Stock Market Triggered a ‘Circuit Breaker'

With stocks looking set to open sharply lower, investors will be watching for key market circuit breakers to kick in and limit or halt the market altogether.

A electronic message board on the floor of the Pacific Exchange displays the mandatory shut downs of Dow Jones Industrials, Monday, Oct. 27, 1997 in Los Angeles. The Dow Jones industrial average suffered its worst single-day point drop in history on Monday, plummeting more than 550 points before trading was automatically shut down for the rest of the day. A circuit breaker automatically halts trading on the New York Stock Exchange for half an hour when the Dow Jones Industrial Average drops by 350 points and again for an hour when the blue-chip indicator drops by 550 points. (AP Photo/Kevork Djansezian)

The S&P 500 fell more than 7% Monday, triggering circuit breakers that temporarily helped halt a further plunge.

The index hit “limit down” shortly after the open, halting trading below that level for 15 minutes. The market resumed trading at 9:49 am ET and continued a decline that saw the Dow Jones Industrial Average briefly shed more than 2,000 points.

In addition to the S&P, the most all-encompassing large-cap stock index, the Dow tumbled 7.3% while the Nasdaq, which is concentrated in technology names, slid 6.9% before trading stopped.

However, about 10 minutes after trading resumed, the major indexes shaved their losses though they remained down steeply for the session and were approaching bear market conditions.

“The market circuit breakers are designed to slow trading down for a few minutes, give investors the ability to understand what’s happening in the market, consume the information and make decisions based on market conditions,” New York Stock Exchange President Stacey Cunningham told CNBC’s Bob Pisani. “This is operating as it’s supposed to.”

What is ‘limit down’?

According to the New York Stock Exchange, a market trading halt may occur at “three circuit breaker thresholds” on the S&P 500 due to large declines and volatility. The exchange classifies this at three levels based on the preceding session’s close in the S&P 500.

The rules, which apply to regular trading hours only, are as follows:

  • Level 1: If the S&P 500 drops 7%, trading will pause for 15 minutes. (This would occur today if the S&P falls 208 points).
  • Level 2: If the S&P 500 declines 13%, trading will again pause for 15 minutes if the drop occurs on or before 3:25 p.m. ET. There will be no halt if the drop happens after that. (This would occur today if the S&P falls 386 points).
  • Level 3: If the S&P 500 falls 20%, trading would halt for the remainder of the day. (This would occur if the S&P falls 594 points).

These circuit breakers have never been triggered in their current form during regular trading hours. The prior circuit breaker system was revamped after it failed to prevent the May 2010 flash crash.  This current set of breakers were put into effect in February 2013.

ETFs tell the tale

Since U.S. futures are pinned at limit down, they don’t tell us all we need to know about how the open might go. Exchange-traded funds based on the indexes, however, continue to trade in the premarket. The SPDR S&P 500 ETF around 7 a.m. ET indicates a 5.9% drop in the S&P 500 once trading resumes. Both the SPDR Dow ETF and the SPDR Nasdaq ETF suggest declines of more than 5.5% at the open. The implied Dow open based on the ETF trade would be a drop of more than 1,500 points after opening limit down.

These ETFs are very accurate in reflecting market trends even when the underlying stocks are not open. The broadest China ETF, the iShares MSCI China ETF, very accurately reflected the drop in Chinese shares in late January and early February even when the China market was closed for more than a week.

CNBC’s Peter Schacknow and Bob Pisani contributed to this report.

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