In an auction market, buyers and sellers simultaneously place competing bids. A stock’s trading price reflects the highest price a buyer is willing to pay and the lowest price a seller would take.
The maximum price a buyer is willing to pay (bids) and the lowest price a seller is willing to accept decides the pricing on an auction market. A transaction only happens when offers and bids are matched. Using auction markets to link buyers and sellers is effective. One example of an auction market is the New York Stock Exchange (NYSE).
Assume, for instance, that ten buyers are interested in purchasing a share of ABC and they make bids ranging from Rs. 10, Rs. 20, Rs. 30, Rs. 40, to Rs. 100.
Ten sellers, on the other hand, want to sell the same shares for Rs 15, Rs 25, Rs 60, and Rs 120. Here, the transaction between the buyer and seller of shares of the ABC Company would take place for Rs 60. The minimum price of shares will subsequently be Rs 60 for all other orders, which will not be executed right away.
In the past, open outcry trading where buyers and sellers called out prices on the trading floor was used to conduct trades in auction marketplaces. Currently, trades in an auction market are electronically executed and are matched instantaneously and simultaneously. The order will remain pending until a matching bid and ask can be made if the bid cannot be matched to an offer price.
In an exchange, there are numerous buyers and sellers participating in the process.
Initial Public Offerings (IPOs) also use auctions. The Dutch auction method is the one used in IPOs. In various stock exchanges throughout the world, auctions are used.
What is auction pricing?
The stock price calculation on the auction day determines the auction pricing. The minimum or lowest auction price will be set at 20% less than the day before the auction’s closing price. If it were lower, you might profit, but the difference would instead be transferred to the Investor Protection Fund (IPF) (some broker may pass the gain to you). However, say that if it is higher, you must make up the difference.
The closing price on the auction day (i.e., T+2 day) will essentially be 20% more than the closing price on the auction day or the highest price in the market up until the auction day from the day of trade (whichever is higher).
The sale transaction is cancelled by the exchange and the defaulting member is required to pay the highest price that prevailed from the day of trading (T) up to a day prior to the auction day OR 20% above the official closing price on the day prior to the auction day, whichever is higher, if the auction is unsuccessful and no one is prepared to sell in the auction (generally happens when the stock hits the upper circuit). These shares’ buyer receives a full refund.
How does the auction market process work?
Since there is no direct negotiations between the buyer and seller, the procedure is different from the OTC market.
- The buyer submits numerous bids for the desired financial instrument that is on the market.
- In the market for the desired financial instrument, the seller makes numerous offers.
- The objective of the order matching mechanism is to match the highest buyer bid and lowest seller offer prices.
- if the lowest ask price and highest bid price are equal. The trading is carried out on those securities, and using this technique, the market price is determined.
- If the bid price and the offer price do not agree, the order status is still “pending.”
- An executed order will be considered for settlement in accordance with exchange regulations.
- In general, there is just one seller and many buyers in the auction. however, there are various buyers and sellers in this.
- Through the use of this order matching mechanism, a continuous process determines the current market price.
- A double auction market is a type of auction market that enables buyers and sellers to submit a price from a given range of bids and offers. When the ask and bid prices are in agreement, the deal will be executed.
Let’s use a practical example to help you understand the auction’s basic idea.
Suresh short sold 1 share of XYZ ltd on Monday for Rs 1080.
The stock must be delivered to the exchange on behalf of Suresh by his broker on Wednesday (T+2 day). Let’s say he fails to deliver.The exchange notifies the broker on this day that these shares have not been delivered, and as a result, bans a certain amount of money from the broker’s account, known as a valuation debit.
The closing price of the securities on the trading day (T+1) immediately prior to the pay-in day serves as the share valuation price for securities that were not delivered on the settlement day. The exchange will block the amount equal to Rs. 1090 from the broker’s account if ZYZ ltd closes at Rs. 1090 on day T+1.
On T+2 day, the exchange holds an auction in which it buys back the stock from the Auction Participant on behalf of the Defaulting Seller. On T+3, the exchange actually returns the shares to the original buyer.
Say the stock was repurchased at Rs. 1110 in the auction market. The exchange will then block an extra amount of Rs 20 (the difference between the purchase price from the auction, which was Rs 1110, and the valuation debit, which was Rs 1090).
However, if the shares had been bought at Rs 930 in the auction market, the difference (Rs 1090-930) would have been given to the Investor Protection Fund (IPF).
However, in the event that there are no sellers in the auction market, the exchange conducts the closeout in the manner described below.
The closeout price will be 20% more than the official closing price on the auction day or the highest price that was in effect on the NSE from the start of trading until that day.
Let’s say that Rs. 1120 was the highest price from the start of trading to the day of the auction. Let’s say Rs. 1110 was the closing price on T+2 day, the day of the auction. Due to this, the closeout will be greater, either Rs. 1120 or Rs. 1332 (1110 * 120%), or Rs (closeout price). In this situation, the exchange will block the additional amount of Rs 42.
Can a client make money through this auction process?
Assume that XYZ ltd closed at Rs. 1040 on day T+1 (this is the valuation debit; it equals the Closing Price of the share not delivered on day T+1 times the number of shares not delivered.
Let’s say the exchange paid Rs 1060 to purchase the share back from the auction market. As a result, the broker’s account will currently be debited for Rs 1060, and your profit will be the Rs 20 difference between the prices at which you sold, or Rs 1080, and the prices at which you bought back in the auction market, or Rs 1060. However, this profit is typically donated to the Investor Protection Fund (IPF).
Online trading is a potential solution to the dilemma of an auction.
It will be simpler for you to keep track of the stocks you acquired and the stocks you now own if you handle all of the transactions yourself rather than relying on a broker. An efficient strategy to prevent the auction of your stocks is to keep track of your portfolio using the best trading software or portal.
From the perspective of the buyer, an auction procedure actually works well. In fact, an auction mechanism is used to deliver the stocks that buyers have bought from sellers. Finacial Media House Acquainting You with Financial Market News (moneynotsleep.com)
Disclaimer: This material is provided for informational purposes only and is not intended to be a recommendation to purchase or sell any specific stocks.