Investing: Decode the bell curve

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Updated: May 1, 2015 1:01:30 AM

A stock’s opening price is more than a mere number. Here’s the lowdown on what it reveals

stock marketUnderstanding market: Have you ever wondered how the opening price of a share is determined? (Reuters)

Have you ever wondered how the opening price of a share is determined? For the uninitiated, opening price is the price at which a share trades as soon as the exchange opens. Generally speaking, it is not the same as the closing price of the last trading day. This is obviously due to news flow and changes in investors’ valuation or expectation of a particular stock.

The mechanics
India’s two premier exchanges — the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) — in October, 2010 introduced a 15-minute window called the pre-open trading session, during which investors can bid for shares before the market opens. This 15-minute window is further divided into the following three slots.
9.00 am to 9.08 am: known as the order collection period, during this you can place orders, or modify and cancel them.

9.08 am to 9.12 am: known as order matching and trade confirmation period, during this orders are confirmed based on the price identification method, popularly known as equilibrium price determination. During this time, no order can be placed, modified or cancelled.

9.12 am to 9.15 am: Known as the buffer period, it facilitates the transition from pre-open to the normal market session.

All market orders are executed at the equilibrium price after it is identified and all unexecuted orders are carry forwarded to the regular or open market as is. During the pre-open session, the price band, or what is known as the 20% circuit, is applicable.

Equilibrium price
The concept of equilibrium price is based on various factors such as demand and supply, the maximum tradable quantity, price at which matches are bought and sold, nearness to the previous day’s closing price, unmatched orders, etc. A combination of these factors is considered while deciding upon the equilibrium price of a share. In essence, this is a four-stage process. At stage one, the order book is sorted and the orders aggregated at different price points.

At stage two, the maximum tradable quantity is ascertained. If there are multiple price points at the same trade quantity, we move on to stage three, wherein the order imbalance is computed. Order imbalance is calculated as the difference between the cumulative buy quantity and cumulative sell quantity at each eligible price point. If there is a single volume maximising price at which the absolute unfilled/unmatched quantity (order imbalance) is minimum, that price is the opening price.

If there are multiple volume maximising prices at which the order imbalance is minimum, the next step comes. In order to arrive at the final price, the potential price is chosen (obtained from the previous steps), which is closest to the previous day’s closing price. This single price point is chosen as the final opening price at which all orders are executed. In case the previous day’s closing price is the mid-value of a pair of prices that are closest to it, the previous day’s closing price itself will be considered the market opening price.

Significance of the pre-open session
The pre-open session plays a significant role, especially when there is a major event or an announcement comes overnight before the market opens. Such events include merger and acquisition announcements, open offers, delisting, debt restructuring, credit rating downgrades or any other information regarding any such event. On a normal day with no such major event before 9.00 am, the pre-open session may appear to be a non-event and might be a routine exercise. However, on a day when there is any major outcome after market closure and before the opening of market hours, this mechanism assumes special significance. It aims at reducing volatility during normal trading hours and indicates the breadth and depth of a particular share.

Closing price mechanism
The closing price of a particular share at the exchange (both NSE and BSE) is calculated through the weighted average price method. During the last 30 minutes, i.e., from 3.00 pm to 3.30 pm, price and volume are taken into account and, accordingly, the weighted average price is arrived at. This price is displayed at 3:40 pm on the BSE and 3:50 pm on the NSE.

To conclude, a company’s opening share price is an important marker for that day’s trading activity, especially for investors interested in intra-day or day trading. Shares that experience very large intra-day gains and losses will have such swings measured relative to their opening price for the day.

The writer is associate professor of finance and accounting, IIM Shillong

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