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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Ask The Expert: How Is A Stock's Price Set Each Day?

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Sometimes the most basic aspects of the stock market can seem like a mystery. Today, we’re taking a look at all of the factors that go into the stock price you see on your trading screen.

Question: What determines the price of a particular stock when the market opens for morning trading?
--Willa, Vienna, Va.

The Investing Answer: The better question may be "who or what..." because it is man or machine that will make that choice, depending on where the stock trades.

For example, all of the stocks on the Nasdaq are controlled by a few thousand traders, known as "market makers," who are tasked with controlling sizable amounts of stock in a few dozen companies each. Each stock may have just a few market makers, or several dozen of them, depending on how popular the stock is.

Roughly half an hour before the market opens, these folks start to put in the prices that they are willing to sell shares to the public (the "ask") as well as the prices that they are willing to buy stock from the public (the "bid"). 

They plug their numbers into the National Association of Securities Dealers Automatic Quotation System (which is where the acronym NASDAQ comes in).

To make sure that consumers get the best price, it will show the highest "bid" and the lowest "ask," so these market makers have an incentive to be very close to the numbers if they are to see trading activity. After all, they make money on every trade, so it would be unwise to maintain bid and ask prices that are out of the action.

Yet trading on the New York Stock Exchange and the American Stock Exchange is a bit different. Instead of market makers, these exchanges are controlled by "specialists" who often control just one (or a few) stock. A crowd gathers in front of the specialist, barking out orders, and the specialist tries his best to come up with a price that equally balances the inputs from buyers and sellers. Many times, computers will handle the trading, and the specialist will only get involved if there are too many sellers or buyers (known as order imbalances).

Sadly, the excitement of watching these floor traders bark their stock orders to specialists may become a thing of the past. Electronic Communications Networks (ECNs) have begun to take over much of the trading action in New York and American Stock Exchange trading. In many instances, these ECNs simply match up buyers and sellers directly, cutting out the middleman and those "bid/ask" spreads.

Exactly 390 minutes after the market opens, it shuts down for the day, at 4 p.m. Eastern time. Most of the time, the closing price for the day is simply the last transaction that took place in the final seconds of trading action. Sometimes, those specialists we noted will fill some straggling late orders that had not been filled, so a few minutes after the market closes, you may see stock prices move a bit more.

And then everything is quiet, at least long enough to get a cup of coffee.

Right at 4:15 p.m. Eastern time, the action gets going again as "after-market" trading kicks in. The trading action here is much lighter, and only more advanced investors should make after-hours trades as the light volume may lead them to get poor prices for their trades.

Trading prices can become so distorted in the "after hours" that they simply get ignored by market makers and specialists in the morning as prices are set anew.

The trading and pricing dynamics for stocks traded in the U.S. but domiciled elsewhere are slightly different. Foreign companies that trade in their own markets and also in the U.S. establish what are known as American Depositary Receipts (ADRs).

Let’s use Sony (NYSE: SNE) as an example. Shares will trade in Japanese yen on the Tokyo stock exchange. The New York Stock Exchange then converts that Japanese price into an American dollar price, which is why Sony and others may have a different price in the morning than they had the prior evening. (Most ADRs are on a one-to-one basis but some local shares are converted into ADRs on a 2-to-1 or 3-to-1 basis).

One final note: Even though stock trading is as simple as clicking a button on a web page these days, a great deal of activity takes place behind the scenes. Even over the course of the trading day, specialists and market makers are continually assessing supply and demand trends for every stock, adjusting their prices on the fly.