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B. Venkatesh

MANY stocks have hit the circuit breaker during the recent market rally. What is a circuit breaker?

The electrical circuit breaker is meant to regulate the flow of electricity — the device trips when the flow gets too high for the circuit to handle. A financial circuit breaker regulates the trading flow in the market. Exchanges halt trading in a stock when its price moves sharply. Why?

Price is a function of demand and supply. Suppose, the demand for the Mangalam Cement stock is higher than supply. The average investor may believe that people are demanding the stock because it is expected to move up for some reason. So, he will also place a buy order. The basic principle of economics tells us that the price will have to go up when demand is more than supply.

When supply is more than demand, the average investor may want to sell. That will lead to a further decline in price. We experience a market crash when supply is more than demand for most stocks in a given day. Stock prices, therefore, move very fast when there is a demand-supply mismatch. It is to prevent such price movement that the exchanges use the circuit breaker.

Suppose a stock closes at Rs 100 on Monday. If the exchange employs a 20 per cent circuit breaker, trading in the stock will be halted if the price rises to Rs 120 or declines to Rs 80 on Tuesday.

Various studies suggest that circuit breakers can lower market disorder. But some argue that circuit breakers are not always useful. Investors may be willing to offload their holding at any price once trading resumes after a stock hits the lower circuit breaker. Such panic selling will further push down the price. Despite such arguments, many exchanges do use circuit breakers.

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