Many online investors go through a ritual each morning.
They sign onto their broker's Web site to check the condition of the market and the prices of specific stocks.
And if they've placed a buy or sell order late the previous day or early that morning, they do something else as well. They read an e-mail from their broker telling them the price at which they bought or sold at that day's market "open."
With individuals placing a crush of orders each night after the market has closed, the start of trading each morning has gotten more frenzied as Wall Street firms scramble to process the orders. By some accounts, as much as 40% of online trades are submitted when the market is closed.
"It's become almost an event unto itself," said Michael Sanderson, chief executive of Eclipse Trading Inc., an after-hours trading firm.
But as the volume of opening trading has surged, so has criticism of the process in which stocks' market-opening prices are set, especially on Nasdaq.
"The opens are getting bigger and there's more and more volume pouring in, so you're getting wildly different fluctuating prices from the [previous day's] close," Sanderson said. "You have no idea what the price is going to be."
The presumed advantage of trading at the opening is that many other investors also are in the market at that point, creating significant "liquidity."
Yet some experts charge that small investors, in particular, often are saddled with inferior "fills"--and that they frequently end up buying at the day's high or selling at the day's low, to the benefit of Wall Street dealers.
Critics say that the New York Stock Exchange specialists and Nasdaq dealers are able to set opening prices that are advantageous to them.
For example, if individuals have put in a large number of buy orders overnight, the Street firms holding inventories of shares to sell have "an incentive to mark that price up at the open, sell all that stock and then get out of the way," said John Wheeler, a senior equity trader at American Century mutual funds.
While that is legal, it can be aggravating for small traders who may get whipsawed.
To see how all this works, it's important to understand the distinct ways the market opens each day on the NYSE and Nasdaq. Both exchanges are open between 9:30 a.m. and 4 p.m. Eastern time, but they trade stocks differently.
On the NYSE, a single "specialist" is responsible for handling the trading of each stock. The specialist determines each day's opening price, and once it's set, all buyers and sellers at the open receive it.
In the half-hour before trading begins, the specialist typically sends out "indications" to floor brokers who represent large investors. An indication is the price range at which a specialist is considering opening a stock.
Based on the indications, floor brokers tell the specialist what their orders would be at various prices. They might, for example, buy more shares at a lower price. The specialist considers that information and sets a final opening price.
On Nasdaq's "dealer" market, prices are set by market makers--the large Wall Street brokerages that stand ready to buy stock from, and sell it to, investors.
Each market maker sets a "bid" price at which the firm will buy a stock from an investor and a higher "ask" price at which the firm will sell it. The market maker typically earns the "spread" between the two prices. So the more volume there is, the greater the potential income generated by the spread.
"That's a big part of the market maker's profit during the day," said Bernard L. Madoff, head of Bernard L. Madoff Investment Securities, a Nasdaq market maker. "They make a lot of money on the spread at the open."
Online brokerages such as E-Trade Group or Ameritrade Holding normally rout their customers' Nasdaq orders to a handful of market makers that actually execute the orders, such as Knight/Trimark Group, Madoff Securities and Herzog Heine Geduld.
The highest bid--the highest price at which any firm would buy stock from an investor--and the lowest ask (the lowest price at which any firm would sell) is known as the "inside market."
Regardless of their own quotes, market makers are supposed to execute customer orders at the inside quote at the open.
For example, say a market maker has a bid to buy WXYZ stock at $51, but the inside market at the open is a bid of $50 and an ask of $50.25. The market maker would buy the stock from its own customers at $50.
Theoretically, therefore, there is a single opening price for each Nasdaq stock just as there is for each NYSE stock. It's the price at which the first trade is executed at 9:30. Indeed, many data systems quote an opening price for each Nasdaq stock.
But unlike the NYSE, that is not a formal price, and there is no guarantee that all orders will be executed at that price, critics say.
And even with the inside-market order-filling rules, Nasdaq market makers can make a lot of money by influencing the opening prices of shares, critics say.
Consider this example from American Century's Wheeler: An Internet stock closes on day 1 at $30. Overnight, a market maker gets "limit" orders from investors to sell 10,000 shares at prices ranging from $30 to $32. Limit orders specify a price at which an investor will buy or sell a stock. If the order is filled, the customer gets that price or better.
The market maker also has "market orders" to buy 14,000 shares, meaning orders to buy at the prevailing market price, whatever it happens to be.
The market maker would seek to have the stock open at approximately a $32 bid and $32.25 ask. The firm would buy the 10,000 shares from the sellers at $32, and turn around and sell them--filling 10,000 shares of the 14,000-share buy orders--at $32.25.
The dealer's profit on the price spread: $2,500.
The firm then would sell 4,000 more shares from its own inventory at $32.25.
The market maker hopes to later buy back those shares at a lower price. In essence, the firm is "shorting" the stock, betting on a price decline.
Why might that be a good bet? With the initial trades pushing the stock up $2.25 in the morning even though the company has announced no news, the higher price naturally attracts sellers, often institutions.
But there is momentarily a lack of buyers now that the overnight buy orders have been filled. So the stock drifts down, giving the market maker the opportunity to buy at the lower price. If the market maker can buy 4,000 shares at an average of $31.50--down 75 cents from the high but still up $1.50 for the day--the firm pockets a quick $3,000.
"The real . . . profit potential is the ability to sell that extra 4,000 shares and then get out of the way," Wheeler said.
Dan Mathisson, head stock trader at D.E. Shaw Securities, a New York-based trading firm, has seen that dynamic many times. "A lot of times after the open it can go in the other direction," Mathisson said.
"The retail guy getting on his computer [later in the day] finds he's bought it [several dollars] from where it closed the night before and then sees it close unchanged that [next] day," Mathisson said.
Research from Plexus Group, a trading-cost consulting firm in Los Angeles, bears that out.
Plexus studied three NYSE-listed stocks (IBM, Merck and Coca-Cola), three big Nasdaq tech stocks (Microsoft, Intel and Dell Computer) and three Nasdaq Internet stocks (Amazon.com, Bid.com International and RealNetworks).
Plexus analyzed trading patterns in the stocks at the open over a nine-day period in late May and early June, focusing on their movements in the first 30 minutes.
On average, the prices of the NYSE stocks fell 0.1% in the first 10 minutes, another 0.1% in the next 10 minutes and barely budged in the final 10 minutes. The Internet stocks, by contrast, rose 0.3% initially, but fell 0.8% in the second 10 minutes and slipped another 0.3% in the final 10-minute span.
Of course, Internet stocks would be expected to be volatile.
In any case, if dealers are supposed to give customers the best prices (the inside-market prices) at any moment, the bigger issue for individuals is dealers' influence over how that inside market is determined at the opening.
In the words of several traders, there is plenty of "jockeying for position" in the market just before trading begins. That's when market makers post stock quotes, even though they're not bound by those quotes and can change them at any point up to 9:30 a.m.
"In the last few minutes before the opening, there are a lot of machinations going on," said Tony Cecin, director of equity trading at U.S. Bancorp Piper Jaffray.
In a nutshell, critics say, the market makers use the pre-opening quotes to influence the inside market to the point they desire.
"Seeing the orders they have in front of them, they jockey around at the opening to get the open to where they want it," Wheeler said.
Nasdaq officials, however, have publicly stated that in their market surveillance they haven't seen anything to suggest that opening prices are unfair.
Even so, in September a Nasdaq subcommittee may consider creating a single-price opening patterned on the NYSE.
But the idea has not been endorsed by Nasdaq itself, and the discussion by the Quality of Markets committee would be informal.
Times staff writer Walter Hamilton discusses the day's market action regularly on the KFWB(AM 980)-Los Angeles Times Noon Business Hour. He can be reached at firstname.lastname@example.org.
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Trading volume in many stocks is heavier in the first hour than at any other time of day. The percentage of the day's total trading Monday in Internet firm Yahoo, by each half-hour*:
* Eastern time
Source: Bloomberg News