Why Do US Stocks "Circuit Break"? Understanding the Three-Level Warning System and Investment Strategies

From Black Monday to Pandemic Shock: Why Do We Need Circuit Breakers?

On October 19, 1987, the Dow Jones Industrial Average plummeted 22.61 in a single day. This day, known as “Black Monday,” profoundly changed the way global financial markets operate. At that time, there were no circuit breaker mechanisms in place, and investors’ panic emotions resembled an out-of-control train, accelerating downward and causing collective crashes across stock exchanges worldwide within hours. It was this catastrophe that led to the creation of modern circuit breakers—a safety device that can forcibly pause trading when market sentiment becomes excessive.

This mechanism is colloquially called the “Circuit Breaker,” much like a building’s circuit breaker automatically trips during an overload. When the stock market experiences irrational extreme volatility, circuit breakers suspend trading, giving everyone a chance to cool down and reassess the market situation, rather than being swept away by collective panic and continuing to sell off in a free fall.

Three-Level Warning System: How Are Circuit Breakers Triggered?

The U.S. stock market currently employs a three-tier circuit breaker standard, based on the decline of the S&P 500 Index compared to the previous trading day’s closing price:

Level 1 Circuit Breaker (7% decline): Trading is paused for 15 minutes, providing investors with a window to think calmly. However, if this warning occurs after 3:25 PM, trading will continue unless a higher-level circuit breaker is triggered.

Level 2 Circuit Breaker (13% decline): Similarly, trading is paused for 15 minutes to further cool market sentiment. If triggered after 3:25 PM, trading resumes.

Level 3 Circuit Breaker (20% decline): This is the ultimate brake; trading halts for the rest of the day, and the market closes directly, leaving no room for negotiation.

It is noteworthy that Level 1 and Level 2 circuit breakers can only be triggered once per trading day. For example, if the S&P 500 drops 7% and triggers a Level 1 circuit breaker, and then drops another 7% after trading resumes, it will not trigger another Level 1, unless the decline reaches the 13% Level 2 threshold.

Why Does the Market Trigger Circuit Breakers? An In-Depth Analysis

Circuit breakers usually occur in two scenarios: one is an unpredictable black swan event suddenly hitting the market, and the other is when the market at high levels encounters information shocks contrary to expectations.

The COVID-19 pandemic is a typical example. As daily new cases surged, people fell into unprecedented panic. To contain the virus, countries implemented social distancing measures, causing economic activity to abruptly halt. Making matters worse, in early March, Saudi Arabia and Russia failed in oil production cut negotiations; Saudi Arabia increased output, causing international oil prices to crash, igniting the fuse for stock market turmoil.

From March 9 to March 18, within just ten days, the S&P 500 triggered four Level 1 circuit breakers—an extremely rare occurrence in recorded history. Warren Buffett once said he had witnessed five U.S. stock market circuit breakers in his lifetime, but ordinary investors experienced four of them in those ten days. As the market continued to decline, fears of recession grew among investors, leading to a rush to sell stocks for safety, creating a self-reinforcing negative feedback loop.

Are Circuit Breakers a Market Savior or a Double-Edged Sword?

From their original design, circuit breakers indeed help stabilize the market: they provide investors with time to think calmly, prevent emotion-driven sell-offs from spreading endlessly, and can also stop extreme volatility caused by high-frequency trading, such as the 2010 “Flash Crash,” when a trader’s high-frequency operations caused the Dow to plunge 1,000 points in five minutes.

However, reality is often more complex. When markets approach the circuit breaker threshold, some investors may rush to sell before the trigger, fearing they will be unable to exit quickly once the circuit breaker activates. This anticipatory selling can exacerbate market volatility and even trigger chain reactions of circuit breakers. Additionally, the temporary halt itself may intensify investor anxiety, making market sentiment even more tense.

Therefore, the effectiveness of circuit breakers must be viewed dialectically—they are indeed a “safety valve” for the market, but not a perfect solution.

Full Market Circuit Breaker vs. Individual Stock Halt: Two Different Protective Mechanisms

Besides the overall market circuit breaker based on the S&P 500 Index, U.S. markets also have individual stock trading restriction mechanisms (LULD, “Limit Up-Limit Down”). When a single stock’s price experiences a large sudden fluctuation, the exchange may impose a 15-second trading halt on that stock. If trading does not resume normally within 15 seconds, trading is suspended for 5 minutes. This mechanism mainly aims to prevent flash crashes caused by algorithmic trading failures or sudden news affecting individual stocks.

Will There Be More Circuit Breakers in the Future? How Should Investors Respond?

Historically, circuit breaker events are not common—since the establishment of the mechanism in 1988, there have been only 5 instances in total, with 4 occurring during the 2020 pandemic. This indicates that the conditions to trigger a circuit breaker are quite stringent.

However, with the global economy facing recession risks and increasing geopolitical uncertainties, the possibility of triggering circuit breakers always exists. If another circuit breaker occurs, investors should adhere to the principle of “cash is king”: prioritize capital preservation and liquidity, maintain sufficient cash reserves, and leave room for potential investment opportunities. During extreme market pessimism, long-term investment opportunities often emerge, provided you have enough funds and the capacity to continue investing.

Rather than trying to predict when the next circuit breaker will happen, it’s better to build an investment portfolio and mental preparedness capable of handling extreme market scenarios, stay rational, and avoid being swept away by collective panic emotions.