Coronavirus chaos isn’t just testing the capacity of our health care system. It’s also probing the limits of the stock market’s “circuit breakers.”

For the third time in the past two weeks, the Dow Jones Industrial Average yesterday hit its emergency circuit breaker as the market opened. The S&P 500 also halted trades.

The Dow on Monday lost 2,997 points, the worst single-day point drop in its history and wiping out 96% of the index’s gains since President Trump took office. The Dow fell 12.9%, the S&P 500 fell 11.9%, and the tech-heavy NASDAQ fell 12.3%.

As of this writing Tuesday morning, all three U.S. indices were bouncing between red and green and struggling to mount a comeback from their historic rout. You can expect volatility into the foreseeable future.

The repeated triggering of circuit breakers lately has prompted several readers to ask me: what are these mechanisms, anyway?

The financial press is in the habit of glibly referring to certain technical terms, without explaining what they really mean. Below, I provide a clear explanation of circuit breakers, so you can make rational investing decisions when markets go haywire.

Curbs on panic selling…

After the Federal Reserve on Sunday slashed its interest rates to near zero at the urging of President Trump, the three main U.S. stock market indexes on Monday posted massive losses, extending the severity of the bear market.

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Investors were spooked by the Fed’s emergency move, because it signaled the central bank’s elevated concern of a recession. Wall Street also knows that lower interest rates can’t reverse a “supply side” problem such as the coronavirus epidemic. And now that rates are at rock bottom, the Fed has painted itself in a corner, with few tools at its disposal when the recession hits.

Which brings us to the repeated emergence of so-called circuit breakers.

Circuit breakers are interventions mandated by regulation to temporarily halt trading on an exchange. The idea is to give panicked investors a chance to catch their breath, before trading spirals out of control. Circuit breakers apply both to broad market indices such as the S&P 500 as well as to individual securities.

Circuit breakers function by automatically halting trading when prices hit predefined levels, i.e. a 7%, 13%, or 20% intraday move for the S&P 500.

As recent examples, on March 9, 2020 and again on March 16, circuit breakers were triggered on the New York Stock Exchange as the Dow Jones Industrial Average plunged more than 7% at the open, due to the fast-spreading coronavirus pandemic and disappointment with government action.

Regulators put the first circuit breakers in place following the market crash of October 19, 1987, aka “Black Monday,” when the Dow shed 508 points (22.6%) in a single day.

A second incident, the so-called flash crash of May 6, 2010, saw the Dow drop almost 1,000 points (over 9%) in a mere 10 minutes. Prices mostly recovered by market close, but the failure of the post-1987 circuit breakers to halt the crash prompted regulators to revise the circuit breaker system.

The circuit breaker system currently applies to both individual securities and market indices. For example, since February 2013, market-wide circuit breakers have been in place that respond to single-day declines in the S&P 500 index. If the index falls by 7% below its previous close, this is known as a Level 1 decline. A Level 2 decline refers to a drop of 13%, whereas a Level 3 decline refers to a drop of 20%.

Previously, the Dow was the bellwether for circuit breakers. However, the most recent rules apply to the whole market when a sharp drop occurs in the S&P 500 (see table).

Level 1 or 2 circuit breakers halt trading on all exchanges for 15 minutes, unless they are triggered at or after 3:25 p.m., in which case trading is allowed to continue. Level 3 circuit breakers halt trading for the remainder of the trading day (9:30 a.m. to 4:00 p.m.). The Level 2 and Level 3 circuit breakers have never been tripped.

In addition to these market-level circuit breakers, there are also circuit breakers for individual securities. Unlike their market-wide counterparts, these individual circuit breakers go into effect whether the price moves up or down. Exchange-traded funds (ETFs) are treated as an “individual security” under the circuit breaker system.

Are circuit breakers worthwhile? There are two schools of thought. Those in favor of them believe they help curb panic selling. By creating a pause, they allow accurate information to flow among market makers, thereby facilitating rational decisions. They prevent speculative gains and dramatic losses within a small time frame.

Others believe circuit breakers keep the free market from efficiently operating. The latter perspective believes that without artificially imposed halts, markets could settle on their own into a more lasting equilibrium. I’m agnostic on the matter, but there’s another mechanism to help you cope with extreme volatility.

A safety mechanism for individual investors…

Here’s an important tool that keeps losses in check: stop loss orders. One of the most widely used devices for limiting the level of loss from a dropping stock is to place a stop-loss order with your broker. Using this order, the trader will pre-set the value based on the maximum loss the investor is willing to tolerate.

If the last price drops below this fixed value, the stop loss automatically becomes a market order and gets triggered. As soon as the price falls below the stop level, the position is closed at the current market price, which prevents any additional losses.

A trailing stop and a regular stop loss appear similar as they equally provide protection of your capital should a stock’s price begin to move against you, but that is where their similarities end.

The “trailing stop” provides an advantage over a conventional stop loss because it’s more flexible. It allows the trader to continue protecting his capital if the price drops, but when the price increases, the trailing feature becomes active, enabling an eventual protection of profit while still reducing the risk to capital.

Over time, the trailing stop will self-adjust, shifting from minimizing losses to protecting profits as the price reaches new highs.

Questions about crisis investing? I’m here to help: mailbag@investingdaily.com

John Persinos is the editorial director of Investing Daily.