Stock auction benefits

Why retail investors should take time to understand specific market mechanics.

Stock auctions are one of the most important parts of the trading day. Multiple buyers and sellers are brought together to take part in a single trade. These have proven popular with many fund managers as a way of trading larger orders with lower market impact, and also as a mechanism for valuing portfolios. The bringing together of many participants to determine a single price has been viewed as a very fair way to value a stock.

In terms of time, auctions only account for about 3% of the eight and a half hour UK trading day, however an average of 25% of daily volume traded in FTSE 100 stocks is executed. The fact that so much volume is traded in such a short amount of time is testament to the popularity of auctions.

Call period

The key to an auction is that continuous trading is stopped for a few minutes. This is known as the call period, during which orders are collected from market participants and begin to run through a matching algorithm.
The purpose of the algorithm is to calculate, for each stock in the auction, the price at which the market can trade the maximum number of shares. This is not about finding the highest or lowest price, but the most popular price. It’s often said that auctions are a very democratic way to trade.

The entire market – fund managers and private investors – come together to agree and trade at one set price.  Call periods will vary according to the type of auction, ranging from five minutes for the closing auction to 10 minutes for the opening auction.
Auctions are used in many markets throughout the world to open and close stock markets, as well as a way to re-start the market if a stock has been halted due to a volatility interruption.

A volatility interruption can happen if a stock moves too much too quickly, triggering an automatic circuit breaker. These act as protection from ‘flash crash’ situations as was witnessed in US markets in 2010.

Removing volatility

The reason why auctions are popular in these situations is that the call period helps remove volatility from the market by slowing down trading, allowing the market to reach a more considered level rather than moving around on individual trades.

Because of their democratic and considered nature, many investors and traders view auctions as a good way of determining a fair value for a stock. This is why auctions are a popular way for fund managers to value portfolios, for indices to set values and for derivatives markets to derive settlement prices.

The London Stock Exchange will be introducing a new auction at 12pm each day from February 2016. This auction, with a shorter, two minute call period will be open to all participants, and provide fund managers with an alternative focal point for trading in the middle of the day.

As the chart illustrates, the most popular auction is the closing auction. This is the auction most used by fund managers and indices for valuations, etc. It also offers an opportunity for traders and investors to complete any orders that they have been working over the day. The closing auction is complemented by a Close Price Cross functionality which allows orders to be submitted after the close and trade at the closing price if there is interest on the other side of the trade.

Auctions can be a very powerful trading and pricing determining mechanism, which is why they are popular with many professional investors. If you are interested in learning more about auctions, please see the London Stock Exchange’s website at www.lseg.com/tradingservices.