Note: One of our students preparing for NCFM Capital Markets (Dealers) Module Exam raised the query in the class about price discovery mechanism in pre-open session at exchanges. Since the subject-matter is not very much clear in the relevant study material, we at Intelivisto thought it to elaborate upon and make it easily comprehendible by the NCFM exam aspirants as well as anyone interested and dealing in the market. So, here we unfold the complicacy of pre-open session for you all. Enjoy learning…..

Discovering Opening Price through Pre-Open Session
In order to discover correct opening price and eliminate/minimize opening volatility in opening prices of securities, SEBI advised the exchanges to formulate a Pre-Open Session of 15 minutes ahead of the normal market using Call Auction mechanism. Earlier, price of first trade in any security used to be ascertained as its opening price, but this practice was manipulated and maligned by forming a cartel to open the prices at one’s desired level.

What is a Call Auction market?
In a Call Auction market, orders are pooled in the order book but remain unexecuted till the end of the order entry period, when the orders will get matched and get executed at the single call auction price that is so determined. At the call, all buy orders are aggregated into a downward sloping demand function and all sell orders are aggregated in an upward sloping supply function. The market opening price and quantity traded are derived based on aggregated supply and demand for the underlying. The orders that trade and the price and quantity at which they trade, are set by multilateral matching, rather than by the sequence of bilateral matching used to determine trades in earlier system of normal market.

Pre-Open Session
Pre-Open Session is a new innovation on exchange side to arrive at the ideal opening price of scrips for the current trading session. The session intends to reduce the volatility that accompanies during the beginning of the day and facilitates better price discovery.
The duration of Pre-Opening Session is of 15 minutes – from 9:00 A.M. to 9:15 A.M. The session has three phases–

Under this new arrangement, the exchange collects the orders for the first few minutes of this session. On the basis of orders received, the exchange arrives at an Equilibrium Opening Price and trades matchable orders on that price. Remaining orders are moved to normal trading session.

Equilibrium/discovery price
An equilibrium/discovery price is the price which is discovered in the pre-open session and all matching orders during pre-open session are executed at this price. Further, the normal market opens at this discovered price.

The equilibrium price is the price at which the maximum volume is executable. In case more than one price meets the said criteria, the equilibrium price shall be the price at which there is minimum order unmatched quantity. The absolute value of the minimum order unmatched quantity shall be taken into consideration. Further, in case more than one price has same minimum order unmatched quantity, the equilibrium price shall be the price closest to the previous day’s closing price. In case the previous day’s closing price is the mid-value of a price or prices which are closest to it, then the previous day’s closing price itself shall be taken as the equilibrium price.
Example 1: Let’s suppose, we have the following Order Book on a scrip:

The system will now calculate the cumulative tradable quantity @ each price

The maximum Tradable Quantity is @ Rs. 95, so the system will mark Rs. 95 as Opening Price and execute the tradable quantity at that price.
If you create a demand – supply curve based on the price and cumulative values, it would look like this.

The intersection of this curve is the price at which maximum transactions can be conducted and that’s the equilibrium price that comes out from this pre-open call auction.

Example 2: Another example of more than one price having minimum unmatched quantity–In the above example 103 and 96 are the prices wherein, the volume tradable and unmatched quantity is the same. To derive the equilibrium price only one price, which is closest to the previous day’s closing price of the said prices i.e. 103 and 96, will be considered. If previous day’s closing price is 95, then 96 may be considered as the equilibrium price. In case the previous day’s closing price is 105, then, 103 may be considered as the equilibrium price. In case the previous day’s closing price 99.5 which is the mid-value of 103 and 96, then the equilibrium price shall be the previous day’s closing price i.e. 99.5.

What happens to the pending unexecuted orders in pre-open session?
Pending unexecuted orders in pre-open session are shifted to the order book of the normal market session. All the unmatched market orders are converted to the limit orders at the discovery price as discovered in the pre-open session and carried forward to the normal trading session. All unmatched limit orders of pre-open session remain at the limit price as specified and carried forward to normal trading session.

In case the equilibrium price is not discovered in the pre-open session, wherein there are only market orders, the market orders shall be matched at previous day’s close price. All unmatched market orders shall be shifted to the order book of the normal market at previous day’s close price following time priority. Previous day’s close price shall be the opening price.

In case of equilibrium price is not discovered in the pre-open session and there are no market orders to be matched, all unmatched market orders (at previous day’s close price) and limit orders shall be shifted to the order book of the normal market following price time priority.