How does pre-market mechanism work and how is the opening price determined of a stock!

To protect small investors against this, a pre-market opening session was introduced to ensure orderly price discovery during the most volatile times

Stock market exchanges have fixed trading hours. During this period, stock prices react to business, economic or political news that dictates the stock trend or market trend. However, in some conditions these announcements are made outside of the business hours of stock exchanges. As a  result, market participants cannot act on this as exchanges are not operational in India for 24 hours or 24*7. So, they have to act on the next trading session.

Development can be interpreted in extremes. Different types of market participants act in different directions. Some market participants expect a positive impact on the stock price and hence, expect stock price to rise, while others may expect it to fall. This in turn would result into high volatility in the stock prices. Hence, there is a probability that it could make reacting to news tough for small investors.

To protect small investors against this, a pre-market opening session was introduced to ensure orderly price discovery during the most volatile times. Indian markets adopted pre-market opening session in October 2010.

Understanding pre-market open session and working mechanism of it

As per NSE “The pre-open session is for a duration of 15 minutes i.e. from 9:00 am to 9:15 am. The pre-open session is comprised of Order collection period and order matching period. The price band applicable shall be same as normal market.”

The pre-open session consists of three segments- an order entry period, an order matching period, and a buffer session.

Let’s us understand each in detail

Order collection session: The order collection session lasts for 8 minutes. During this sub-session, the tasks undertaken include order placement to buy and sell stocks and modification and cancellation of orders. Orders are not accepted after these 8 minutes end.

Order matching period: The order matching period starts immediately after order collection session and order matching period lasts for 4 minutes, from 9:08 am to 9:12 am. These four minutes are used up on order confirmation and order matching. After matching the orders, the opening price for the day is calculated. Orders are matched at a single (equilibrium) price which will be open price. When the order matching period is ongoing, market participants aren’t permitted to buy, sell, cancel or modify their orders.

Buffer session: The last 3 minutes i.e., between 9:12 am and 9:15 am are for a buffer session. Any irregularities, if existing, are cleared. The session facilitates the transition from the pre-open market to the normal market session.

Understanding Equilibrium determination:

In a call auction price mechanism, equilibrium price is determined as shown below. Assume that NSE received bids for particular stock xyz at different prices in between 9:00 am and 9:15 am. Based on the principle of demand supply mechanism, exchange will arrive at the equilibrium price – the price at which the maximum number of shares can be bought / sold. In below example, the opening price will be 105 where maximum 27,500 shares can be traded.

Image source: NSE

NSE has mentioned “During order matching period order modification, order cancellation, trade modification and trade cancellation is not allowed. The trade confirmations are disseminated to respective members on their trading terminals before the start of normal market. After completion of order matching there is a silent period to facilitate the transition from pre-open session to the normal market. All outstanding orders are moved to the normal market retaining the original time stamp.”

Limit orders are at limit price and market orders are at the discovered equilibrium price. In a situation where no equilibrium price is discovered in the pre-open session, all market orders are moved to normal market at previous day’s close price or adjusted close price / base price following price time priority.

The opening price is determined according to the principle of supply and demand mechanism. The equilibrium price is the price at which maximum volume is viable. If multiple prices meet the above criteria, the equilibrium price is the price with the unadjusted minimum order quantity. If multiple prices have the same minimum order quantity, the equilibrium price is the price closest to the previous day’s closing price. If the previous day’s closing price is the average of the price pairs closest to it, then the previous day’s closing price itself is considered to be the equilibrium price. For corporate actions, adjust the previous day’s closing price to the closing price or base price.