Stock prices will always fluctuate — daily, monthly and annually. You need to accept this reality if you're going to be a long-term investor. But you do have some protection from extreme volatility — in the form of "circuit breakers" and "trading collars."
These strange-sounding terms refer to mechanisms designed to restrict "program trading" on the New York Stock Exchange. Program trading is a system of buying and selling stocks based on signals from computer programs, usually sent directly from a stock trader's computer to the market's computer system. Using this technique, major traders can buy and sell huge amounts of stocks in an instant.
Program trading was at least partially blamed for the stock meltdown in October 1987. Consequently, trading restrictions — such as circuit breakers and trading collars — were launched to prevent program trading from sending the markets into turmoil.
Each quarter, the New York Stock Exchange sets new circuit breaker levels, which represent the thresholds at which trading is halted. Circuit breakers are triggered by 10 percent, 20 percent, and 30 percent drops in the Dow Jones Industrial Average, based on the Dow's average closing values of the last month of the previous quarter.
To understand how circuit breakers work, consider the thresholds set for the second quarter of 2002:
• A 1,050-point drop in the Dow before 2 p.m. would have halted trading for one hour; if the same drop had occurred between 2 p.m. and 2:30 p.m., trading would have been halted for only 30 minutes. And if the 1,050-point threshold had been reached after 2:30 p.m., it wouldn't have stopped trading at all.
• A 2,100-point drop in the Dow would have halted trading for two hours if the decline had occurred before 1 p.m., but only one hour if it had happened between 1 p.m. and 2 p.m. And if the Dow had fallen 2,100-points after 2 p.m., trading would have been halted for the day.
• A 3,150-point drop, at any time, would have halted trading for the rest of the day.
As you can see, circuit breakers are fairly easy to understand. But trading collars are a bit more complex. Trading collars restrict index-arbitrage trading, a strategy that professional traders use to profit from the difference in value between stock indexes — such as the S & P 500 — and "futures" contracts on those indexes. So, for example, a trader might buy the less expensive S & P 500 futures contract while simultaneously selling the more expensive underlying stocks of the S & P 500 index. Often, the price difference between the index and its futures contract is only a few cents. But because these traders — or "arbitragers" — trade such huge numbers of contracts at the same time, they can make big profits. And heavy arbitrage activity can greatly affect stock prices.
Just as it does for circuit breakers, the New York Stock Exchange sets new trading collar trigger levels every quarter. If the Dow Jones Industrial Average falls or rises a certain number of points, trading collars go into effect to restrict index-arbitrage trading.
Circuit breakers and trading collars may seem far removed from your everyday investment activities, but these restrictions are there for your benefit. You can't stop market volatility — but at least you know it won't be allowed to run amok.