Large Price Shifts at the Close -- Why?

Have you ever noticed that right at the close of the market, the price of a stock sometimes suddenly jumps up or down dramatically, and possibly outside the current range of the bid and ask spread? Here are some of the reasons why this happens.

There are three common explanations for a price jump at the close of a day.

These are:

• Prearranged sale being recorded (by far the most common)
• Arbitrage closing transaction (occasional appearance)
• Market order, good-for-day only, with volume far in excess of bid/ask spread (rare, but probably happens)

There are probably other explanations as well, but these are the most common. By far the most common reason is the prearranged sale.

When the price of a stock suddenly jumps at the end of the day, it is helpful to look at the list of actual transactions that occurred.

If there is a single transaction with a large number of shares behind it, at a price well out of the range of the current bid/ask spread at the time, the transaction is almost certainly a prearranged sale. It is not uncommon to see a single transaction at the end of the day with a volume that is larger, sometimes several times larger, than an average day's entire volume.

In such an event, the transaction is really only a transaction of record. It does not accurately reflect the market trends for trades of more "normal" trading volumes.

Prearranged sales occur when a large holder of a stock wants to sell their position, or when an investor wants to purchase a large position, but wants to minimize the impact of this decision on the current market price.

In such a situation, the buyer or seller contacts an actual broker, usually by telephone, and asks them to find the other part of their transaction. During the day, the broker makes calls and tries to arrange the purchase at an agreed upon price. 

When the broker is able to find a buyer for the selling party, or a seller for the buying party, the price is generally arranged over the telephone.  This prearranged deal might happen much earlier in the day, perhaps even in the morning.

In such a prearranged sale, the selling market maker and the buying market maker are often the same party. A good broker might find both sides of the transactions within his own client base, meaning he/she can capture a commission from both parties.

The actual transaction is passed through the exchange to record the purchase/sale, but by placing the transaction at the end of the day, the intent is to have as little impact on the overall market trends as possible. Any premium paid by the buyer, or lost by the seller, is considered "acceptable" for being able to move such a large block in a single transaction. 

When the price jumps upward at the end of the day, particularly if that price is the high of the day, you can safely assume that the prearranged sale was initiated by the buyer of the large position.  If the price drops, you can assume the prearranged sale was initiated by the seller.

With the actual purchase and sale decision being made earlier in the day by a middle-man on the telephone, such prearranged sales are really a throw-back to the old days, when brokers played a much more significant role in daily transactions.

Another possible explanation for sudden price jumps at the end of a day might be computer programmed trades attempting to capture an arbitrage profit at the close.

If there are several transactions of varying volume sizes, with multiple market makers on either side of the transactions, the most likely explanation is an arbitrage program. If the transaction prices for these "jumps in price" transaction are all the same, or very close to each other, yet still outside the bid/ask spread before the transactions appear, computer program trading is the likely explanation.

In such a situation, the computer program has calculated a price at which simultaneous transactions of opposing nature (such as selling the futures, buying the underlying stocks) will provide a guaranteed profit. 

The computer program instantly places sell orders for one side of the transaction at a limit price while also placing buy orders for the other side with limit prices.

If the volume in the buy/sell orders are larger than the quoted volume in any of the market maker standing orders at that time, the transactions can occur at the limit price, even though the limit price is outside the current bid/ask range.

The "computer program" doesn't care that the buy order was executed at a price higher than the current ask, because the limit associated with the order will still ensure that arbitrage strategy is profitable, if the corresponding sell order is also transacted at the predetermined limit price.

The risk behind such arbitrage computer programmed trades is that the offsetting transactions are not both executed. If only one of the sides of the trade is executed, the calculated "sure thing" profit does not occur.

For computer trading arbitrage programs to work, both sides of the transactions must be guaranteed to happen.

This is why such orders are often placed at the end of the day, with limits outside the current bid/ask spread, because it is almost certain to attract a market maker who will take the risk behind such an "instant profit."  The risk that market maker faces, if they fill the order from their own inventory, is that the market will shift before they can cover their short position or sell their long position.

If such a computer arbitrage order is placed earlier in the day, market makers are more reluctant to take up the order instantly, since such a transaction is likely to alter the current bid/ask price immediately.

Maker makers are only obligated to fulfill any standing market offer at the bid/ask price and volume listed.

Any offer that appears with a volume larger than any listed order does not constitute an obligation for the entire volume, even if the bid price is higher than the current offer or the ask price is lower than the current bid. The market maker is only obliged to fill such an order for the currently listed volume.

In fact, if the "outside-the-spread" offer is listed as "all-or-nothing" with a volume greater than the volume of the currently listed bid or ask offers, there is no obligation at all for a market maker to fill the order instantly. Such orders might be filled, but computer trading often involves very large volumes, requiring large capital commitments from market makers.

Any hesitation by a market maker might mean that the timing of the two offsetting transactions becomes large enough to erode the calculated arbitrage profit. 

In an attempt to ensure close timing of transactions, computer arbitrage orders are placed at the end of the day, with good-for-the-day qualifiers. This minimizes the risk that one side of the arbitrage will not be filled, or will be filled after market shifts have eroded the expected profit. 

When a large price jump occurs at the end of the day and is represented by several transactions of unusually large volume, the explanation is likely that the transactions are part of a computer trading arbitrage program.

The most nefarious explanation for a large jump in a stock price at the end of a day is the one we often see people asserting in message boards and chat rooms, but the truth is, it rarely happens.

This explanation is that someone has placed an "at-the-market" order with a volume outside the current bid/ask volumes and a market maker decides to simply gouge such a buyer or seller with an outrageous price.

Market orders placed with volumes lower than the current bid or ask price must be filled by the maker who listed that bid or ask offer. However, the currently listed bid and ask offers are only those at the "top-of-the-list."  Bid orders with lower prices and ask orders with higher prices are waiting in the queue with their associated volumes.  When an open bid/ask offer is filled, the next offer in the queue becomes the current offer.

While we explained above that orders with volumes greater than currently listed bid or ask offers are not obligations for market makers, market makers are free to fill such orders, if they choose. This is the situation that some people describe as the "gouging" explanation for sudden price jumps at the close.

In fairness to the market makers, such orders rarely happen. While the volume listed for the bid/ask spread at any given time is usually low, sometimes just 100 or 200 shares, the list of bid/ask offers in the queue with lower bids or higher asks is often extensive, with very large volumes on some orders. By definition, these are "limit" orders, but an opposing market order that meets the limit requirements will cause such a limit order to be filled. 

In order for a market maker to "gouge" a market order at an arbitrary price, it would mean that such a market offer would have to be outside of all currently listed bid and ask offers and their currently listed volumes. This is simply a very unlikely situation, as anyone with access to Nasdaq Level II quotes can observe for themselves.

While we think such situations probably have happened, they are much rarer than most people think.

Comments may be e-mailed to the author, Robert V. Green, at rvgreen@briefing.com