On Thursday, May 6, 2010, the Dow Jones Industrial Average had its worst intra-day drop in its 128 year history, dropping nearly 1000 points. Initially, there was a lot of finger pointing and speculation by the exchanges as to who was at fault. It was even rumored that someone had placed an errant trade to sell multiple billion shares instead of multiple million shares.

However, the Wall Street Journal reported the following day that “…exchanges reviewed their audit trails and so far have found nothing indicating a massive erroneous trade that touched off the chaos.” The WSJ further reported that “A senior Obama administration official on Friday afternoon told Fox Business Network that a so-called fat finger error wasn’t at the root of Thursday’s price swings.” Furthermore, Reuters reported that “Five days after the Dow Jones Industrial Average fell 9.2% in a matter of minutes, regulators still have not gotten to the bottom of what caused the unprecedented swoon.”

At this point, the logical outcome seems to be that the selloff wasn’t accidental or erroneous at all but due to normal economic factors, including the concerns with Greece and the falling of the Euro. This should serve as a reminder to investors as to how volatile the economy really is. For those folks that lost a lot of money last Thursday but got most of it back before the end of the day, they should feel fortunate. However, the next time the market crashes, they may not be so lucky.

During all of the chaos and mixed reports, you most likely heard the media report that one of the changes being proposed is to establish a circuit breaker system for individual stocks. Since I’ve received many questions from my clients as to what this means, I felt compelled to write this article.

As a result of the market volatility in October of 1987 and 1989, the New York Stock Exchange initiated the circuit breaker concept which mandates that if the market drops below a certain level, trading would be temporarily halted. Currently, the circuit breakers work as follows:

• If the market declines 10% before 2:00 p.m., the market will halt for an hour.
• If the market declines 10% between 2:00 p.m. and 2:30 p.m., the market will halt for 30 minutes.
• If the market declines 10% after 2:30 p.m., there is no halt.

 
Furthermore:

•  If the market declines 20% before 1:00 p.m., the market will halt for two hours.
•  If the market declines 20% between 1:00 p.m. and 2:00 p.m., the market will halt for an hour.
•  If the market declines 20% after 2:00 pm, the market closes for the day.

 
Furthermore:

• If the market declines 30%, the market closes for the remainder of the day regardless of the timing of the drop.

 
While most professionals agree that the circuit breakers are a good idea, there has been a constant debate as to whether these percentage limits are too high. Since their inception 22 years ago, there has only been one day that they have been triggered, on October 27, 1997, when the Dow was down 250 points at 2:35 p.m. and 550 points at 3:30 p.m., shutting down the market for the remainder of the day.

Because the events of last Thursday seemed to be triggered by a select number of stocks that were particularly hit hard, the idea of establishing a circuit breaker system for individual stocks has been put on the table. If this idea gains traction, presumably the circuit breakers that currently apply to the stock market as a whole will be applicable to individual stocks should a major decline occur.