Managing an orderly market and ensuring that share prices are not able to be manipulated by participants seeking an unfair advantage over others are important functions of the Australian Securities Exchange (ASX). The arrangements for the opening and closing of markets are particularly important in this regard. Among other things, closing prices can determine margin calls, the terms of exercise of derivatives contracts, the pricing of some capital raisings, remuneration under employment contracts and the calculation of market indices.
Consequently, the stock exchange, like many other markets, has developed special procedures to allow for Buy and Sell orders to be placed before and after normal trading, and for any of these orders which match or overlap to be settled at prices which are established differently from those applying to orders placed during the normal trading day.
The Pre-opening pricing formula involves 4 steps. If the price is established at any step, then the remaining steps are not needed. This method, used to establish prices in the Pre-open period, also applies in precisely the same way to establish;
- closing prices at the end of the trading day,
- float prices,
- prices following a trading halt or suspension, and
- prices of new listings.
It is often said in all of these circumstances that the market is in “Pre-open”, even though that might seem to be a strange way to describe the state of the market at the close of the day.
This approach enables optimal opening prices to be established, maximises order matching when the regular trading session begins, reduces the load on the exchange’s trading system (ITS) and helps manage price fluctuation and manipulation at the beginning and end of the normal trading session.
Some investors are very suspicious of these arrangements. This quote from a blog on the internet shows a lack of confidence and knowledge that is not uncommon. Advisers who discuss direct shares with their clients should be ready to explain why these sentiments are not accurate, and how the prices of these trades are calculated.
“We all know it goes on: before 10 am, any number of stocks are quoted with sort of reverse quotes, phoney quite obviously. The sellers selling dirt-cheap, the buyers offering prices way above last night’s close, right up to the official start of trading…
I’d like to know, what is the rationale behind all this? Does it serve any practical purpose? if these people are joking, isn’t it time the exchange put a stop to this silly practice?”
Pre-open periods are particularly vulnerable to manipulation, and some practices which are always prohibited but which are particularly relevant to the Pre-opening periods are;
- Order Stacking or Layering of bids (placing Buy orders at various price points below the market to create a false appearance of buying demand).
- Marking the close (trading a stock near the close, with the objective of affecting the closing price).
- Wash trades (both Buy and Sell orders are entered by the same party to artificially inflate turnover, or influence the price of a security).
- Matched Orders (placing an order in the knowledge that an associate intends to make a corresponding offer to buy or sell the same securities on the same terms).
- Placing orders then cancelling them without apparent reason, especially close to the market open or before or during the afternoon Closing Single Price Auction.
Before we look at the pricing calculations, the following is a reminder of the various phases of the Integrated Trading System (ITS) throughout a normal trading day.
From 7 am to 10 am, no trading takes place. Brokers and investors enter orders which are ranked in order of price then time. This is the morning Pre-open.
At a time randomly chosen by a computer to be within 15 seconds of 10 am, share codes beginning with A or B commence trading. Existing orders that can be matched are traded at the Match Price (see below) established in the Pre-open.
The remaining stocks open progressively in tranches every two and a quarter minutes (+/- 15 secs) until the 5th and last block of stocks (S to Z) starts trading at 10:09 (+/- 15 secs).
Up to 4 pm the market trades normally.
For 10 minutes after 4 pm brokers enter, change or cancel orders ahead of the close. Trades do not take place, but Match Prices are calculated, updated and displayed. This period is known (oddly) as the Pre-open prior to closing.
For just 2 minutes from 4:10 pm (+/- 15 secs) a Closing Single Price Auction (CSPA) takes place. The auction takes place with all trades in any particular stock taking place at the Match Price which was determined in the Pre-open according to the rules discussed in this article.
The system is then available for adjusting then purging orders, and finally for system maintenance, before closing for 12 hours from 7 pm.
Match Prices in the Pre-Open
Because orders can be entered during Pre-open but trades do not take place, orders may ‘overlap’. This means that highest Buy orders may be at a higher price than the lowest Sell orders. Special rules are required to resolve the difficulty this creates.
For example, a stock in Pre-open has a Buy order at $10 and a Sell order for the same quantity at $8. ITS will not trade these ‘overlapping’ orders. When normal trading (or the CSPA) resumes, these ‘overlapping’ orders will trade at a price known as the Match Price or Single Price Auction. The Match Price is continually updated as new orders enter the system.
But what should that price be? If the system set the price in our simple example at, say, $9.00, then both parties would be satisfied. The buyer would be buying more cheaply than her order specified, and the seller would get more than he was prepared to accept. However, this will be the case at any price between $8 and $10. While it may appear to be fair to “split the difference”, that may not be the fairest solution in the real world, when many orders at various prices and volumes will often exist.
Note that the method described only has effect if there are overlapping orders. If the highest Buy order for a stock in Pre-open is lower than the lowest Sell order, then no trades take place and those orders will remain in the queue established by price and time in the system until cancelled, amended, purged or traded in the normal way in the open market.
Calculating the Match Price To calculate the single Match Price, four principles are applied in order. Each stage provides a filter for the next, so that only those possible prices that survive from the first stage are considered in the second. If only one price is possible after applying the rules at any stage, then that becomes the Match Price and it will not be necessary to go to a further stage.
Consequently, if a price can be established under the first of the principles, then that will be the Matched price. The fourth principle always establishes a single price.
The principles applied are these.
- The price should be the one that provides the maximum volume of executed trades.
For example, if there are 70,000 buy orders at a price of $10 or less, and 30,000 sell orders at $10 or more, then clearly 30,000 shares would trade if the price were $10. If there were a price at which a higher number of trades would take place, then that would become the Match Price under this first principle. If the exactly the same volume of trades would be executed at more than one price, then a choice among them will be made by applying the second principle
- The price should be the one that leaves the least quantity of shares in unfilled orders.
For example, in the example used in principle 1, 30,000 shares would trade if the price were $10, and 40,000 buy orders would remain unfulfilled. If any other price that was still a possibility after principle 1 resulted in fewer unfulfilled orders, then it would become the Match Price. If the same quantity of shares in unfilled orders would arise at more than one price, then a choice among them will be made by applying the third principle
- The highest potential price should be used if market pressure is on the buy side, the lowest if the pressure comes from sellers.
For example, using the same example again, if two prices remained from principle 2, then the higher of them would become the Match Price, because the unfilled orders are on the buy side. If pressure comes from both sides, the final principle will be applied.
- The price should be set with reference to the last traded price.
If the last traded price is within the range of potential prices that are still possible after applying Principle 3, then that will be the Match Price. Otherwise, the Match Price will be the potential price that is closest to the last traded price. For example, assume two prices, $10.90 and $11, are still possibilities after principle 3 is applied. If the last traded price was between these prices, for example $10.95, then that would be the Match Price. If the last price had been $11.05, however, that would lie outside the range, so the closest of the possible prices, in this case $11.00, would be the Match Price.