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Trader's Corner

Curbing the Markets

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On July 1, the NYSE made a little-heeded announcement. As it does each quarter, the exchange updated the levels at which restrictions would be imposed on trading the SPX component stocks. For the rest of the current quarter ending September 30, CNBC would have to pull out its "Curbs In" banner if the Dow Jones Industrials were to move more than 200 points away from the previous day's close. That banner has been absent so long that new traders might never have seen it.

Those "Curbs In" banners used to be more common near the turn of this newest century, but disappeared as markets settled into long periods of range-bound trading. They're still waiting to protect markets from periods of extreme volatility and are updated at the beginning of each quarter. According to some sources, trading curbs were first codified after the crash of 1987, when some market watchers theorized that program trading had intensified the selling.

In NYSE nomenclature, curbs would actually be called collars. Rules 80A and 80B set forth the rules that pertain to collars and circuit breakers, actual halts in trading. Curbs would be imposed if the Dow were move more than 200 points away from the previous day's closing value, but removed if it traded back within 100 points of that previous day's closing value. They could be re-imposed again if the Dow were to move 200 points away from that previous close again. Although movements of the Dow trigger the collars and circuit breakers, restrictions and halts apply to all S&P 500 component stocks.

For this quarter, trading in the S&P 500 components stocks would actually be halted if the Dow were to fall more than 1050 points from the previous day's close. The exchange calculates this amount by determining 10 percent of the average closing values of the Dow for the month before the beginning of the quarter. Trading would be halted for an hour if the circuit breaker had been imposed before 2:00, but only 30 minutes if it had been imposed at 2:00 or later, but before 2:30. After 2:30, trading would not be halted unless the Dow had fallen more than 2100 points from the previous close by that time. A decline of 2100 points would trigger a Level 2 halt, and perhaps many a heart attack, too, with Level 2 representing 20 percent of the Dow's average closing value for the previous month. Depending on the time of day such a drop occurred, the halt might last as much as two hours. That happens if the Level 2 halt occurs before 1:00. At 1:00 or later, but before 2:00, a one-hour halt occurs. At 2:00 or later, trading would not resume for the rest of the day. Level 3 halts occur, too, on a 30 percent drop below the Dow's average closing price for the prior month. For this quarter, those would happen if the Dow were to drop more than 3150 points from its previous close, shutting down trading for the rest of the day.

Notice that while the exchange imposes trading curbs or collars when the Dow moves either up or down by a certain amount, it halts trading only when the Dow drops by a certain amount. The exchange would not stop trading if the Dow were to gain 3000 points above the previous day's close, not unless the stampeding bulls were to wreck the place, that is. Those curbs or collars would be in place, but the trading not halted. It's also important to remember that these rules don't address the halting of a specific stock due to news or some event requiring that action.

Those Rules 80A and B define the type of trading activity that will be restricted as well as the levels at which those restrictions will apply. Trades initiated because of differences between a basket of stocks and derivatives of those stocks--including cash-settled options, futures or options on futures--would be considered index arbitrage trades and would be restricted if the exchange had imposed collars. The basket of stocks and the derivatives named don't have to be traded at the same time to be included in this definition of index arbitrage trades. Program trades would include this type of strategy or any tactic that would trade a group of 15 or more S&P 500 stocks with a total market value of $1 million or more. Such basket trades don't require the purchase of derivatives to be considered program trades.

So what happens to index arbitrage or program trades after those curbs are imposed? Index arbitrage or program sales of S&P 500 component stocks must be marked "sell plus" after a 200-point drop triggers a collar, and must be marked "buy minus" when a 200-point gain triggers a collar. According to one source, a sell-plus order is one in which the price is equal to the previous transaction price, but more than the most recent different transaction price. Investopedia describes the term more simply, saying that the sell order would be placed at a price above the current market price. A buy-minus order would be one when the price to buy is the same as the previous transaction price, but less than the most recent different transaction price. Also said more simply, the order would include instructions to buy at a lower price than the current market price.

These curbs are meant to slow the plunge or the melt-up, as the case might be. This last month, some SOX or Russell 2000 bears must have wished that such collars and circuit breakers had been in place on those indices. Unfortunately, it just ain't so and those bears will just have to wait for natural market forces to apply some curbs.

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