Following the 1987 stock crash, the Securities and Exchange Commission directed both stock and derivative exchanges such as the Chicago Mercantile Exchange, to implement circuit breakers, or pauses in trading. In the futures markets, they re known as limits.

In response to last week s plunge (and subsequent recovery?) in stocks, the SEC is again demanding U.S. stock exchanges tighten rules to slow or stop trading in rapidly falling markets. Chairman Mary Schapiro has proposed more trading halts (now called time out mechanisms ) that would be applied to individual stocks in addition to the stock indexes themselves.

Unfortunately, the government s efforts to stabilize markets by halting trade will have just the opposite effect: making stocks more volatile, less efficient and lower returning. Trading halts shouldn t be expanded, but eliminated.

For a moment, imagine if upon finding out you had brain cancer, your doctor decided instead to tell you it was simply a head cold to avoid frightening you. You d rightly be outraged. Regardless of how upsetting or painful the diagnosis, you d naturally want to know the reality of the situation immediately.

Yet it is exactly that evasion which occurs with price limits, as with the various other interventions we ve highlighted over the past few years.

The entire function of a market is to allow buyers and sellers to discover prices and freely transfer risk. If you wish to provoke panic buying, simply create an upside limit. If your goal is to cause a collapse, just create a maximum permitted decline.

Think like an investor for a moment and not a power-hungry politician intent on controlling prices. If the S&P 500 futures contract is only permitted to fall 55 points, what would motivate one to step in and buy (i.e., stabilizing prices) when the contract was down 54 points?

Once trading is halted you are unable to get out at any price. That uncertainty is precisely what creates the panic and hesitancy to provide liquidity during times of market stress.

Conversely, when a market nears its upside limit, speculators who would normally be selling short, (thus stabilizing prices from rising) will instead scramble to close their positions, pushing prices even higher. Why take the risk of selling just as the market is about to go limit up? What if the market opens limit-up again tomorrow?

Data suggest that the trading halts effect on the market makes them more volatile. Over the life of the S&P futures contract, 7,108 trading days, the market has had an average daily return of 0.0323% with a daily standard deviation (volatility) of 1.2743%.

On the 137 days when trading halts of any kind occurred, the average daily return was -1.13% with a standard deviation of 2.12%, meaning that trading halt days tend to be lower returning and more volatile than a normal trading day.

Moreover, markets don t return to a normalized state for a least two full days after the halt is instituted. Rather than calming markets, such intervention makes stock more volatile and lower returning for two more days.

Trading Halts Increase Volatility, Lower Returns

S&P 500 Futures Contract

There s a social cost as well. Preventing willing, voluntary buyers and sellers from trading is a loss of information to the market as to just what the price of XYZ is. The same bureaucrats who smear Wall Street as manipulative shysters fully support trading halts that deceive investors by sending the unwanted signal that this game is in fact safer than it actually is. If you can t trust a price what good is it?

As we pointed out last week, the financial markets are far from free.

Every element about securities trading in this country is closely regulated, from the exchanges to the companies who list their shares to products like futures or ETFs as well as the brokers, dealers, firms and funds.

The trading halts regulators now trumpet as fixing the markets already exist with negative consequences. As demonstrated by the data, markets waste two days adjusting to the shock of a trading halt, a period during which returns are lower and volatility is higher than it otherwise would be. This is the effect regulators seek to expand?

While the politics of limiting trade might play in Peoria, the fact is that limits, closures and circuit breakers actually increase risk, both directly and indirectly, for every single investor.