MT481 Unit 7 Order Book Equity Market Analysis Example

Where the Opening Price Comes From: An MT481 Unit 7 Equity Market Analysis of One Stock's Order Book

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Purdue University Global

MT481: Financial Markets

Unit 7 Equity Market Analysis

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[Date]

Talbot Instruments, its order book and the market maker's quotes are composite; the sources cited are real.

The Stock and the Book

Talbot Instruments is a composite maker of laboratory instruments whose shares trade on a national exchange. Before the market opens, orders accumulate in the exchange's opening auction. Buy orders include 900 shares at market and limit orders to buy 1,100 shares at 42.30, 1,400 at 42.25, 2,800 at 42.20, 1,800 at 42.15 and 1,600 at 42.10. Sell orders include 600 shares at market and limit orders to sell 1,200 shares at 42.05, 1,400 at 42.10, 2,600 at 42.15, 2,400 at 42.20 and 2,000 at 42.25. A buy limit order will trade at its price or lower; a sell limit order at its price or higher; market orders trade at whatever price the auction sets.

The Auction Table

For each candidate price, the auction table totals the shares willing to buy and the shares willing to sell at that price. At 42.10, buyers want 9,600 shares and sellers offer 3,200, so 3,200 would trade. At 42.15, buyers want 8,000 and sellers offer 5,800, so 5,800 would trade with 2,200 shares still wanting to buy. At 42.20, buyers want 6,200 and sellers offer 8,200, so 6,200 would trade with 2,000 shares left unsold. At 42.25, buyers want only 3,400 and 3,400 would trade.

The exchange chooses the price that matches the most shares, 42.20, with 6,200 shares. Every buyer willing to pay 42.20 or more is filled. On the sell side, everyone selling at market or at limits below 42.20 is filled, 5,800 shares, and only 400 of the 2,400 shares offered at exactly 42.20 execute, by time priority. The opening print is 42.20 on 6,200 shares.

The opening price is simply the price at which the most shares can change hands.

Harris (2003) describes call auctions of this kind as a way to concentrate liquidity at moments, such as the open, when information has built up overnight and continuous trading would produce erratic prices.

The Imbalance Left Over

The auction leaves 2,000 shares offered at 42.20 unsold. Exchanges publish such imbalances shortly before the open so that traders can add orders to absorb them, and a large imbalance often draws new buyers or sellers who see an opportunity. Here the unsold shares stay on the book as the best offer when continuous trading begins, which means the first buyers of the day can trade at 42.20 without moving the price. The imbalance therefore tells observers something about the day ahead: sellers outnumbered buyers at the open, and the price may drift lower unless new demand arrives.

Continuous Trading

After the open, trading becomes continuous. Orders arrive one at a time, and a trade happens only when a buyer and a seller agree at that moment. When few orders are arriving, someone has to stand ready to trade. That is the market maker's job.

Suppose a market maker quotes Talbot at 42.18 bid and 42.21 offered, for 500 shares on each side. If one investor sells 500 shares to the market maker at 42.18 and another later buys 500 from it at 42.21, the market maker earns the 3-cent spread on the round trip, $15. That small profit pays for providing immediacy, the ability to trade now rather than wait for a natural buyer or seller.

The Market Maker's Risk

The spread is not free money. If the market maker buys 500 shares at 42.18 and the price then falls 4 cents before it can sell, it loses $20, more than the $15 a full round trip would have earned. The bigger danger is trading with someone who knows more. Glosten and Milgrom (1985) showed that market makers widen spreads to cover losses to better-informed traders, so a stock with more uncertainty about its value, or more informed trading, carries wider spreads.

What Determines Liquidity

Talbot's 3-cent spread reflects several features. The stock trades often enough that the market maker can expect to unwind positions within minutes. Its price is stable on most days. And there is little news pending. A smaller company with fewer trades, more volatile prices or an earnings release due would see wider spreads and thinner order books. Madhavan (2000) reviews research showing that spreads rise with volatility and fall with trading volume, which is the pattern a reader would expect from the market maker's arithmetic above.

What the Analysis Shows for Investors

For an ordinary investor, the analysis has two practical lessons. A market order at the open accepts whatever price the auction sets, which is usually fair because the auction gathers so many orders, but can be poor on a day with an imbalance. A limit order protects the price but may not fill, as the sellers at 42.20 discovered when only 400 of their 2,400 shares traded. And during the day, the spread is a real cost of trading: buying at the offer and selling at the bid costs the investor what the market maker earns.

References

Glosten, L. R., & Milgrom, P. R. (1985). Bid, ask and transaction prices in a specialist market with heterogeneously informed traders. Journal of Financial Economics, 14(1), 71-100. https://doi.org/10.1016/0304-405X(85)90044-3

Harris, L. (2003). Trading and exchanges: Market microstructure for practitioners. Oxford University Press.

Madhavan, A. (2000). Market microstructure: A survey. Journal of Financial Markets, 3(3), 205-258. https://doi.org/10.1016/S1386-4181(00)00007-0