Will Your ETFs Be Affected By The Proposed Circuit Breaker Rules?

A few days ago, on its anniversary, I reviewed the flash crash of 2006, the impact it had on the investing public along with the “do’s” and “don’ts” when using sell stops.

The WSJ (subscription required) had a follow up story about the resulting proposals for a trading-halt system for stocks and ETFs. Let’s look at some highlights:

The current trading halts, known as circuit breakers, briefly pause trading in shares of certain securities that rise or fall by 10% or more in a five-minute period, guarding against rapid price swings. The system originated in the weeks following the May 6, 2010 “flash crash”–when the Dow Jones Industrial Average plunged nearly 1,000 points before quickly rebounding–and applies to securities in the Standard & Poor’s Composite Index of 500 stocks, the Russell 1000 stock index and 344 exchange-traded funds.

Under the expanded circuit-breaker system now being proposed by U.S. stock exchanges to the Securities and Exchange Commission, stocks and exchange-traded funds priced at or above $1 that are not currently part of the circuit-breaker program would experience trading halts following moves of 30% or more in a five-minute period. Stocks and exchange-traded funds priced below $1, meanwhile, would experience trading halts following moves of 50% or more in a five-minute period.

The proposal comes as the U.S. exchanges seek a way to curb the volatility in more securities while another proposed system of trading limits–known as “limit up/limit down”–is working its way through regulatory red tape.

…

The “limit up/limit down” system, which would replace the circuit-breaker system, was proposed a month ago and would prevent trading in a stock from occurring outside set price bands. Under it, the share prices of stocks currently covered by the circuit-breaker program wouldn’t be permitted to move by more than 5% above or below the average share price in the preceding five minutes. The trading band would be set at 10% for all other stocks.

The limit up/limit down system is preferred by many market participants because it would only trigger halts if trading is unable to continue within the pre-set price band for more than 15 seconds. That proposal has a lengthier path to approval–the SEC has 120 days to act on it after it is published in the Federal Register, versus a 45-day period following Federal Register publishing in which the SEC must decide on the proposal to expand the circuit breakers.

While it’s too early to tell if these proposed changes will have the anticipated effects if and when another flash-crash hits the markets is anyone’s guess. What is important is the fact that serious efforts are being made to protect the investing public from a repeat performance of May 6, 2010.