Rule #1 Finance Blog

With Investor Phil Town

Rule #1 Question of the Week: Opening Price vs. Closing Price

Q:

Hi Phil Town,

I have a simple question. The software I am using lets you set the moving average based on the opening  price or the closing price or the high or the low for the day. Which one do I select?

Peggy

A:

Peggy's investing software for Tools gives her four choices for price input to the Tools from the market.  The high price, low price, opening price or closing price.  So if you have a similar choice, which one should we choose? 

The simple answer is usually best:  choose the closing price.

The reason is that the research done on almost all of these tools by
their original developers used closing prices as the input for price.
And that is not just arbitrary.  Options traders will tell you that
2:30 in the afternoon is when the real action starts.  Between then and
the closing bell things can really change.  That's because many day
traders and options traders do not want to hold a highly leveraged
position overnight.  There are too many examples of bad news coming out
of nowhere after the closing bell.  That means the closing price is
often the closest price to what the market thinks about that stock on
that day.

You can really see this at work on the first days of an IPO — Initial
Public Offering.  Before the first day of trading in a new stock, the
investment bankers take the corporation's management team on a tour of
brokerage houses across the US to have the managers tell their business
story and to let the brokers ask questions.  This is called the "Dog
and Pony Show" because it takes on a certain show-ring air. 

After the
dog and pony show is over (usually about a week) the investment bankers
call around and get a sense of what the investors out there are telling
their brokers about whether they want to buy the stock on the opening
day and at what price.  The trick for investment bankers is to set the
price high enough that the company owners feel they didn't sell it too
cheap and low enough that the stock will go up after it goes public to
please the new investors.  They set the stock price right before the
first day and hope they got it right. 

After the opening bell, their
brokers sell to the investors who expressed a desire to buy in the
prior weeks.  Those sales are the opening price.  As the day goes
along, the investment bankers (and the opening bell investors) hope and
pray that there was a backlog of investors who couldn't get shares at
the opening who still want shares at that price.  If there are lots of
them, the price will move up as demand exceeds the supply of sellers.
But by the end of the day, the price may return to the opening price or
even go below it, depending on how the public thinks about the future
of this company relative to its price. 

For most experienced investors,
the opening price is going to reflect a lot of hype from the day before,
while the closing price, theoretically, is a sober reflection of
reality.  Or so they say. 

The reality is, of course, always changing.
Still, we have to use something consistent, and so we use the closing
price for the input into these tools. 

Now go play.

Phil Town