Determination of Opening Price of a Stock

With the opening bell of stock exchange every morning, we usually find an unusual disparity between the opening prices of a stock from its previous day’s closing. Have you ever wondered what causes this variation?

Well, the reason for this difference in prices might be attributed to the role played by the media. Even though the stock exchange closes at 3.30pm, the news channels go round the clock. The investors/traders (buyers & sellers), based on the impact of these news items, place their orders with their respective brokers. Since the exchanges are not active during these non-working hours, these orders have to be settled with the opening of markets. The entire list of the buy and sell orders is being received by the respective exchanges before the opening of the market.

So how do the exchanges narrow down on the opening price of a particular stock? Here the law of supply and demand comes into the picture. Let me try to explain this using the below tabulated data.

	Buyer Data			Seller Data
No. of Shares	Limit Price	Cumulative No. of Shares	No. of Shares	Limit Price	Cumulative No. of Shares
100	105	100	50	101	50
200	104	300	100	102	150
400	103	700	350	103	500
100	102	800	500	104	1000
500	101	1300	100	105	1100

Limit price for a buyer is the maximum price the buyer is willing to pay for a particular stock. Similarly, the limit price for a seller is the minimum price a seller is seeking for a particular stock. The buyer side of table clearly shows the maximum price a buyer is willing for this stock is Rs. 105. On the other hand, the lowest price at which a seller is willing to sell is Rs. 101. 

But the aim of the exchanges is to maximize their profits i.e. greater would be the settlements, greater would be the revenue generated. So let us try to understand how this opening price of stock is determined?

Suppose the stock opens @ Rs 101, then we have 1300 potential buyers but only 50 potential sellers. So settlement of only 50 shares can be carried out at this price. Certainly not a very profitable price for stock exchanges. This price clearly demonstrates an excess of demand but a short of supply. Thus, the price chosen is too low as per law of demand & supply.

Had the opening price of stock would have been Rs 105, we would have had 1100 potential sellers but only 100 potential buyers. In this case, supply exceeds demands, showing the opening price is on a higher side.

If the stock would have opened @ 102, we would have had 800 buyers versus 150 sellers. Now, @ 103, we have 700 buyers as compared to 500 sellers. Clearly, we are narrowing down on demand-supply mismatch.

Similarly, @ 104, there would have been 1000 sellers but only 150 buyers. So for the exchanges to maximize their revenue, Rs. 103 seems the most appropriate price resulting in the settlement of 500 shares.

Here only a simple table has been taken to demonstrate the entire process of determination of opening price. In reality, the quantum of pre-market orders is quite large and large networks of computers are used to calculate the opening price based on above mechanism.

So, even in something as volatile as share market, the archaic law of demand and supply holds true! 

[via optionsatoz.com]