By Bryan Wiener

On May 31, 2013, the SEC approved a change to the Limit-Up/Limit-Down circuit breaker mechanism that was implemented in June 2010 to combat excess volatility in US single-stock equities.

The aim is to prevent unnecessary circuit breaker triggers that have occurred in previous market sessions via erroneous trades. Think the Apple (NASDAQ: AAPL) mini flash-crash. Essentially, this new rule will use exchange matching engines to prevent such trades from occurring outside of pre-specified market bands.

The basic mechanics to the new circuit breaker revolve around a price band. To create the price band, a rolling arithmetic mean for the stock over the previous 5 minutes is calculated based upon Eligible Reported Transactions. This rolling arithmetic mean is called its Reference Price. Simultaneously, a 5%, 10% and 20% up and down bands are calculated (lower priced symbols have separate parameters).

For example, if the National Best Offer (NBO) of XYZ stock is below the current 5% band price and it does not improve within 15 seconds, trading will halt for 5 minutes (Tier 1 violation). Upon reopening, an auction will occur in the stock’s primary market exchange, which will create a new Reference Price. XYZ will remain open unless it moves below the 10% band (Tier 2 violation), whereupon it will have another trading halt. If XYZ violates the 20% band the stock will be closed for the remainder of the day.

The arguments for these new rules essentially surround market manipulation and erroneous trading occurrences that may or may not be due to high frequency trading (HFT). Given that HFT is over 60% of US equity volume, coupled with the technology they utilize to internalize information from various media sources, it only makes sense to implement a safety valve. The US equity market is far too vulnerable to market manipulation and withdrawal of HFT “liquidity”, two of the primary reasons generic customer market orders often execute at extreme and unreasonable prices.

These circuit breaking situations may occur when false news is disseminated on social media sites. We saw how the market reacted last week when Twitter was hacked. When a false statement was released that the White House was attacked and President Obama was injured, the market dropped dramatically in the blink of an eye. These new measures provide comfort to investors and professional traders that fabricated events won’t allow for significant losses (although it is possible for slippages of up to 5% of the Reference Price).

Debate has risen over the proper pricing of the Reference Price. Some argue that an arithmetic mean is improper and instead favor a volume-weighted average price (VWAP). However, volume-weighted average price (VWAP) will discredit lower volume, more extreme stock prints- the very prints that the SEC is trying to put an end to.

To take an extreme situation, if a stock trades 1000 shares at $100 and 100 shares at $104, the arithmetic mean Reference Price = $102, while the VWAP Reference Price = $100.36. Essentially, the circuit breaker will set off far too late when using the VWAP Reference Price and more extreme prints will occur. The SEC was correct in choosing an arithmetic mean calculation method.

After the events in 2008, the Flash Crash and the AAPL Mini-Flash Crash, circuit breaker implementation is necessary for the security, safety and sanity of the US equity investor. It is borderline national security. As for option trading, it also prevents Black Swan events that could wipe out brokerage firms via the leveraging characteristics of option contracts. The SEC acted accordingly on multiple levels and should be commended for their actions to improve upon the circuit breaker’s predecessor.

Bryan Wiener traded in the CME S&P 500 Options pit before receiving his Masters in Financial Mathematics from the University of Chicago. Upon graduation he joined Trading Machines as a systematic options trader. He currently works as an adviser at Haim Bodek consulting while trading as an independent professional.