Three tips for trading ETFs
July 08, 2024
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4 min read
With the popularity of exchange-traded funds (ETFs)1 on the rise, investors should be aware of how to trade them effectively. Unlike mutual funds, ETFs can be bought and sold on exchanges during market trading hours, similar to stocks. However, as ETFs derive their underlying value from a portfolio of securities, trading requires specific considerations that differ from buying and selling individual securities. Here are three important considerations when trading ETFs.
Trading tip 1: Consider avoiding the open and close
The modern market structure has become increasingly fragmented, and not all markets open up at exactly the same time in the US – therefore, all stocks may not be available for buying/selling at the same time. Avoiding trades when the market opens may be beneficial when trading ETFs, as large trade imbalances can exist for certain underlying securities that can delay their opening as market makers2 work to find equilibrium pricing between buy and sell orders. Stock values may also rise or fall based on buyer/seller reactions to overnight news or earnings reports. The resulting price volatility of underlying securities directly impacts the price of ETFs that own those stocks.
Many market makers manage risk by widening their spreads and reducing their depth (or shares available to trade) in times of uncertainty, including at the market open. It may also be prudent to avoid trading at the market close, as market makers might not be willing to take on more risk at the end of the day. Remember, market makers ideally want to end each trading session with a flat book – an order book free of outstanding orders – due to the increased risk of carrying open positions overnight or over a weekend.
Trading tip 2: Be aware of different types of orders (market orders vs. limit orders)
Various types of orders can impact an investor’s trading outcome as they can send signals to the market. In ETF trading, three order types are particularly important: market orders, limit orders and block trades.
- Market orders3 – the decision to buy or sell a security immediately at current market prices – demand liquidity at any price and prioritize speed of execution over price control. For most investors, the priority is just the opposite: price control over speed of execution. Market orders can expose an investor to price execution above net asset value, resulting in a premium paid for an ETF – especially when spreads4 are wide.
- Limit orders5, on the other hand, set a desired price level, and trades are executed only at a specified, or better, price. Using limit orders can protect an ETF order from an execution that differs significantly from the intrinsic value of the portfolio. Limit orders are especially important when purchasing an ETF with low trading volume. Market makers are normally willing to facilitate larger trades by accessing the liquidity of the underlying securities but may not show their entire depth on electronic trading platforms. By setting a marketable limit order (for example, close to the bid or ask), market makers can react to your order and provide the liquidity necessary.
- Limit orders may be at risk of not being filled completely if (1) the limit order is set too far away from the bid or ask, at an unreasonable price level; or (2) for structural reasons, the limit order would be only partially executed if the market price hits the stated limit and the trade is activated, but the market price never reverts to a favorable price.
- It may be advisable to avoid good 'til canceled (GTC) orders6 and use day orders7, as an investor should reassess the limit price on each new trading day.
- Block trades are considered more “high touch” in that they involve the investor getting in contact with their custodial trading desks to source additional liquidity that might not be shown on-screen with “low touch” market or limit orders. The custodial block desk will put multiple liquidity providers into competition to provide the best possible price for the client. If the trade is large enough, liquidity providers will source shares from both the secondary and primary market to meet demand. By tapping into the primary market through creations or redemptions, the underlying security liquidity of the ETF portfolio is accessed – which can lead to more favorable price execution. Lastly, a block trade will be implemented in a single order that, for an advisor, ensures that all clients receive the same price. Leaning on a block trade desk for trade execution services or even general trading advice is a way for investors to gain in-depth expertise from experienced ETF traders.
Trading tip 3: When trading during turbulent times, sometimes less is more!
When markets are volatile, there is a cost associated with demanding liquidity. Liquidity becomes scarce amid market stress – exactly when investors need it most. Most market participants are not obligated to make markets and will protect themselves in volatile times with wide spreads and thin markets8 (limited shares available to trade). The arbitrage opportunity that makes ETFs attractive can be impaired when market makers cannot assess the risk and the true intrinsic value of the underlying portfolio.
At times of market stress or dislocation, traders may want to step back and trade only when absolutely needed. If a trade is necessary, then investors should carefully compare the underlying portfolio to the ETF price and ask questions if something seems amiss before execution. Every ETF issuer has a Capital Markets desk that can explain the intricacies of their products and pricing methodology. Fully transparent ETFs allow investors to go look "under the hood" on a daily basis to fully understand the underlying securities and how the product is constructed.
During periods of heightened volatility, it is especially important to stick to a defined investment strategy to weather the storm. ETFs can serve as powerful tools over the long term to help investors meet their investment objectives and lead better financial lives.
