Also called a 'collar', it is a defensive mechanism followed by stock exchanges to limit the damage of sharp fall in prices which, in turn, can lead to panic sales.
Circuit breakers are designed to reduce market volatility and were instituted following the stock market crash of 1987.
They temporarily restrict trading in stocks and commodities, options and index futures when prices fall too far, too fast.
An upward movement over the threshold will cause a contract to enter an upper circuit. Similarly, a downward movement in price beyond the threshold will cause a contract to enter a lower circuit. When a contract enters an upper circuit, it puts an investor at an advantage.
On the contrary, a contract movement into a lower circuit places the investor at a disadvantage as it is difficult now to sell off his/her contracts as they would have lost a lot of money.
For example, trading on the National Multi Commodity Exchange is halted when the rubber prices rise or drop two per cent anytime of the day.
On the New York Stock Exchange, trading is halted when the Dow Jones Industrial Average drops 10 per cent any time before 2:30 p.m., sooner if the drop is 20%.
However, if the DJIA falls 30% from the previous day's close, there are rules allowing NYSE to stop trading for the rest of the day.
In India, the Sensex moved up by 2110.79 points on May 18, 2009 after parliament election results were announced.
The trading had to be halted since the market became extremely volatile and moved beyond reasoning.
In Indian commodity exchanges, the first circuit breaker comes into play for most commodities when prices rise or drop by four per cent.
Trading is halted.
After the cooling period, trade is again halted if overall prices are up or down by six per cent.