How To Trade ETFs: A Practical Guide For Retail Investors

When you talk about trading ETFs, you have to talk about two kinds of trades.

For retail investors or for advisors and institutions making small purchases, ETFs mostly trade like stocks. The bid/ask offers you see in your brokerage account—or, if you're fancy, the Level 2 trading screens you can access—show you the market you'll trade against. There are still good and bad trading strategies, and we outline those below, but for the most part, ETFs at this level trade like stocks.

For investors making large trades, the situation is totally different. ETFs have one big difference from single stocks: If there is demand for an ETF, a special class of institutional investor (called an authorized participant) can create new shares by buying up the securities the ETF wants to hold and turning them in for shares with the ETF issuer.

In other words, if you have a stock that trades 1,000 shares a day, you have no chance of buying 100,000 shares of that stock without getting absolutely killed on the trade. For an ETF trading 1,000 shares a day, however, you could work with a liquidity provider to purchase an almost-unlimited quantity—as long as you know how.

We have a series of articles on how to trade ETFs on this site. This article deals with best practices for executing smaller trades. For larger or more sophisticated investors, we encourage you to read the related articles at the bottom of this page.

Market Orders

The simplest type of ETF trade to enter with your broker is a market order. It can also be the most dangerous.

When you place a market order, you're telling your broker you want to trade an ETF right now—at whatever price it takes to attract shares. If the market is offering the ETF at $49.90 on the bid and $50.10 on the ask, and you want to buy, your market order for 100 shares will probably get filled at $50.10.

Generally speaking, however, market orders are a terrible idea: Investors can get hurt in at least three ways.

First, if you're trading more than 100 shares, there's no guarantee your trade will execute at the publicly available spread. That spread—what you see in your brokerage account—reflects only the best bid and offer in the nation, which sometimes may be for just 100 shares. If you want to buy 1,000 shares, or 10,000 shares, you can blow past this inside spread and get your order filled at a cost well above the $50.10 you saw on the screen.

Second, many ETFs trade with wide advertised spreads to begin with. Less liquid ETFs may show spreads of 10 percent or more—an absurd price that mostly reflects the fact that no one is paying attention. But if you're putting a market order in, those will be the prices you get. You could get a much better price with a simple limit order.

Third, the markets can move between the time you decide to trade and when your order gets into the system. There can be flash crashes, market panics, technical glitches … and you'll have no control over where your trade will be executed.

Market orders should only be used for the largest, most liquid ETFs where guaranteed, split-second execution is important to your strategy. For most investors, market orders should be avoided at all costs.

Limit Orders

One step better than a market order is a limit order. A limit order tells your broker the maximum price you're willing to pay for an ETF, or if you're selling, the minimum price you'll take. It protects you from wildly bad executions, although it means your trade won't happen if the market moves away from your order.

Limit orders can be very helpful in getting an execution between the spread. If a given ETF is advertised at $49.50 on the bid and $50.50 on the ask, and the fair value is actually $50.00, chances are that a limit buy order placed closer to that $50.00 mark will get executed and save you $0.50 a share, if you're patient.

When in doubt, use a limit order.

Using Liquidity Providers

For investors placing large trades, one additional option exists: working with liquidity providers. Liquidity providers are large institutional market makers who exist (at least in part) to help investors buy and sell ETFs. Think of them as facilitators.

A description of how to work with these liquidity providers and execute large trades is available in the next article.

Next: Who Are Market Makers And What Is Step-Away Trading? (AKA, How To Get Big Trades Done Right)

RELATED ARTICLES

Who Are Authorized Participants?
Understanding ETF Liquidity
Understanding Spreads And Volume

 

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