ETFs Made Easy: Spreads & Trading

December 16, 2014

In this series, we answer the questions investors are afraid to ask. You can submit your questions to me at [email protected]. All correspondence will remain anonymous.

In previous columns, I’ve covered the basics of what a fund is, and how to think about the fees associated with ETFs. Those cover the “fund” part of ETF, but what about the “exchange traded” part?

If you’ve only ever invested in mutual funds, the idea of trading shares of something on an exchange can be a bit alien. It’s actually both simple and easy to understand. After all, one of the biggest things on the Internet is really just an exchange: eBay.

My Little Pony

Imagine you want to go buy a Twilight Sparkle My Little Pony on eBay. You find the one you want, and you tell the seller that the most you’re willing to pay is $10. When the auction is over, the person willing to pay the most is the one who gets the toy. If it was you, you get the Little Pony.

The stock market works the same way, except instead of having just one person selling just one Twilight Sparkle, there are thousands of collectors all trying to sell their Twilight Sparkles, and thousands of collectors trying to add to their collection. And the auction never ends.

You tell eBay how much you’re willing to pay, and as soon as eBay finds someone willing to sell you the Little Pony for $10, that transaction is done. If someone else decides they’ve had enough Twilight Sparkle in their life, they tell market the lowest price they’ll sell for—say, $11—and when someone is willing to pay $11, the transaction happens.

The Trading Book

At any given time, all the information on buyers and sellers is collected in what’s called “the book.” In the days before computers, it was literally a book, with orders to buy listed on one side of the page, and orders to sell listed on the other.

At the top of the page would be listed the very best offers at the time—$10 offered by you to buy, and $11 for sale on the other side. At any given moment in time, that difference between the best bid and the best ask is called “the spread”—which in this case is a dollar.

When you want to buy or sell shares of an ETF through your broker, that’s exactly what happens. You ask for a quote (usually just by typing in a ticker) and your broker will respond with something like “XYZ: 101.22 x 101.30,” meaning the best you can buy for right now is $101.30, and the best you can sell for is $101.22. Usually, the amount that’s offered at those prices is pretty small—100 shares, which is why how you put your order in is important.

Types Of Orders

The two main kinds of orders you can place are called “limit orders” and “market orders.”

With a market order, you’re telling the market, “I want to buy or sell so many shares and I do not care at what price.” So in the above example, if you put an order in to buy 1,000 shares, you might get the first 100 shares for $101.30, but for the next 900, you’re at the mercy of how badly other people want to sell. You’ll almost certainly pay more than that $101.30 on average.

A limit order solves this problem by saying, “I want to buy so many shares, but I will pay no more than X dollars. “ So a limit order to buy 1,000 shares here requires you to state your price—perhaps $101.28, which is between the current bid and ask.

That order will sit there until someone decides to take your price. You will in fact change the quote that the market is showing, because, before, the best offer was $101.22; now, you’re the best offer, at $101.28. It’s possible, however, that you could simply never get your shares (your “fill” in street parlance).

That’s the trade-off with a limit order—you get to set your price, but you have no guarantee of getting your shares. With a market order, you know you’ll get your shares, but who knows at what price?

In general, we never recommend investors use market orders—you don’t go to a restaurant and say, “I’d like food now, no matter how much it costs,” do you?

Most ETFs trade very well, meaning, the spread between the best bid and the best ask is quite small, and plenty of shares are available from the marketplace. But it pays to look at the “tradability” tab of our fund reports to make sure, and to always check the quote and to use limit orders with your broker.

What About Mutual Funds?

 

Mutual funds work differently—you can only trade them once a day, at the end of the day, at a price determined to be the fair value (called the “net asset value,” or NAV) by the fund company.

ETFs give up that end-of-day NAV trading in favor of letting you trade when you want to through the market. There are pros and cons to both structures—the traditional mutual fund gives you certainty that you’re getting fair value, the ETF structure lets you trade when you want to.

In a future installment, I’ll talk about NAV, and what it means for ETF investors.


Contact Dave Nadig at [email protected] or on Twitter @DaveNadig.

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