Trading Strategies during Circuit Breakers and Extreme Market Movements

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Author Information : Kenneth A. Kavajecz

Year of Publication : 2004

Summary of Findings : Liquidity providers withdraw from the market during a crash, particularly when there is a chance trading may be halted. There is a “magnet” effect whereby trading activity accelerates prices toward circuit breaker triggers.

Research Question 1 : How do liquidity providers (limit order traders and market makers) behave during a market crash?

Research Question 2 : What effect do circuit breakers have on market participant behavior?

What we know : During the market crashes of 1987 and 1997, a circuit breaker shut trading down for a period of time to allow for a pause.

There is a debate about whether circuit breakers help or hurt the market.

Novel Findings : Circuit breakers historically were used based on the number of points the market had fallen – 500 points shuts the Dow Jones down for an hour while 1,000 points shuts it down for the rest of the day. This research argued it should be based on percentages instead; after the paper was published, the market moved toward percentage criteria for circuit breakers.

Demonstrated the “magnet effect” or the idea that trading halts to the point that the market takes a dive.

This is the first time researchers documented that liquidity dries up running up to and after a circuit breaker is triggered.

Implications for Practice : Demonstrates that circuit breakers, the inability to trade potentially changes the way people trade, making them more skittish and unwilling to continue trading.

Research led to a change in the way circuit breakers were implemented – using a percentage criteria rather than points.

Implications on Research: First time anyone has documented that liquidity dries up during a circuit breaker.

Full Citations : Goldstein, Michael A. and Kenneth A. Kavajecz, 2004, Trading Strategies during Circuit Breakers and Extreme Market Movements, Journal of Financial Markets 7: 301-333.

Abstract : This research examines the 1997 crash where a circuit breaker was used to curtail a rapidly falling stock market and seeks to determine what happens during the shutdown period. Findings describe the “magnet effect,” the notion that circuit breakers change the way people trade, making them more skittish and reluctant to get back in when the market reopens. Researchers further documented, for the first time, that liquidity dries up during a circuit breaker, literally stopping trading altogether for a period of time. As a result of this research, the markets in general base decisions to implement a circuit breaker on percentage change in the market rather than point drop.

Kenneth Kavajecz

Kenneth Kavajecz

Professor Kavajecz is dean of the Whitman School and professor of finance. He has focused much of his research on the structure of financial markets, with an expertise in liquidity, trading, risk management, market structure and regulation.
Kenneth Kavajecz
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