On Wall Street, "circuit breakers'' refer to stock market trading halts that prevent markets from spiraling out of control when prices drop too quickly. These circuit breakers indicate excessive short-term volatility, but they shouldn't worry long-term investors.

According to NYSE President Stacey Cunningham, circuit breakers "are designed to slow trading down for a few minutes, to give investors the ability to understand what's happening in the market, consume the information and make decisions based on market conditions."

You might remember the successive circuit breakers that hit stocks in March of 2020. Amid growing uncertainty about the COVID-19 pandemic, markets endured a series of crashes that set off circuit breakers four times over two weeks. Prior to that, marketwide circuit breakers like that hadn't been used for over 20 years.

An electronic display board shows stock prices falling.

Image source: Getty Images.

How do circuit breakers work?

Marketwide circuit breakers are based on declines in the S&P 500 index within a single session. The curbs are triggered at three different thresholds: after a 7% drop, a 13% drop and a 20% drop. For the 7% and 13% drops, trading is only halted for 15 minutes, but if the S&P 500 Index (^GSPC 1.20%) drops a full 20%, trading is halted for the remainder of the day. Securities exchanges work together with futures and options markets to activate and coordinate these marketwide circuit breaker halts.

The market can also slam the brakes on any individual stock with Limit Up-Limit Down (LULD) circuit breakers. These kick in if a stock's price moves either up or down outside of specified price bands, set at 5%, 10% and 20%, within the preceding five minutes of trading. Single-stock circuit breakers are much more common and happen everyday. Unlike marketwide circuit breakers, LULD circuit breakers are designed to curb both panic selling and its opposite, "manic buying."

History of circuit breakers

Wall Street implemented marketwide circuit breaker halts in 1988, in reaction to the Black Monday crash of Oct. 19, 1987, when the Dow dropped more than 22%. 

After Black Monday, President Reagan appointed a task force called the Brady Commission to prevent such a crash from happening again. The Brady Commission proposed that a system of circuit breakers be put in place to avoid future stock market crashes.

Sparking frequent marketwide halts during their first few years, circuit breakers went full tilt on Oct. 27, 1997, when a global "mini-crash" occurred. This prompted market regulators to make major adjustments to be made to circuit breakers, most notably switching from point-based to percentage-based thresholds. 

Since 1997, marketwide circuit breakers have only been triggered four times -- all in March of 2020.

Do circuit breakers work?

While you can argue that imposing price controls on a market makes it less free, circuit breakers do seem to make sense. In the four times they were implemented in March 2020, three of the halts were deemed successful, with the S&P 500 leveling out around the 7% down mark. However, on March 16, after the initial 7%-down trigger, the market continued to trade down to almost twice that deficit. Not perfect, but three out of four isn't bad.

"Circuit breakers can't produce miracles," wrote Brady Commission chairman Nicholas Brady and executive director Robert Glauber. "They can just provide a 'breather,' a chance to interrupt panic." 

No one knows when circuit breakers might kick in again, halting a dramatic market slide. But long-term buy-and-hold investors likely shouldn't be concerned with trading curbs and market halts. After all, the S&P 500 has more than doubled since these emergency brakes were last activated.