[This article appears in our January 2020 edition of ETF Report.]
ETFs trade like stocks. ETFs trade nothing at all like stocks. Both of these statements are true. But to trade ETFs, you should know why this is so.
The place to start with understanding how ETFs trade is to understand how individual stocks trade.
At any given time, there are two prices for any common stock: the price at which someone is willing to buy that stock (the “bid”) and the price at which someone is willing to sell (the “ask”). The difference between these two prices is called the “spread.”
The reason spreads exist is because, in any open market, folks try to negotiate the best prices they can get. If you’re looking to buy, you’ll naturally want to see if someone is willing to sell for less than the last traded price.
Conversely, if you’re selling, you’ll naturally hope that someone will be willing to buy it for more than the last quoted price. Spreads are simply the result of buyers and sellers negotiating on prices.
For example, let’s imagine Microsoft’s stock is trading with the bid at $49.90 and the offer at $50.10. The spread is therefore $0.20. If someone asked you what a share of MSFT was “worth,” you’d probably choose the midpoint: $50.00, or maybe the last price at which you can see a trade actually happened.
But if you wanted to buy MSFT right now, you’d probably have to pay $50.10. If you wanted to sell right now, all you’d get is $49.90. Those are the prices you’d get if you enter a market order into your brokerage window.
The wider the spread, the more it will cost you to trade MSFT.
Bid/ask spreads are so important to ETP trading because, unlike a mutual fund—which you buy and sell at net asset value—all ETFs trade like single stocks, so ETFs trade with bid/ask spreads. That’s the price of the “exchange-traded” in the name.
Spreads widen and narrow for various reasons. If the ETF is popular and trades with robust volume, then bid/ask spreads tend to be narrower. But if the ETF is thinly traded, or if the underlying securities of the fund are highly illiquid, that can also lead to wider spreads.
Overall, the narrower the bid/ask spread, the lower the cost to trade.
Volume & Market Impact
However, when trading stocks or ETFs, you also have to look at volume and so-called market impact.
Volume is the number of shares that trade on any given day. The higher the volume, the better. For example, if MSFT trades, on average, 10 million shares per day, it’ll be easier to trade than something that trades 100 shares per day. Note, however, that spreads could be tight on both, which could mislead unwitting investors to conclude that both securities are equally liquid.
Typically, the number of shares offered on the “bid” or the “ask” will be small—sometimes 100 shares, sometimes more, but rarely a huge amount. If you try to buy 10,000 shares of something that only trades 100 shares per day, you could have trouble.
To go back to our MSFT example, someone might be willing to sell you 100 shares of MSFT at $50.10, but if you want to buy 10,000 shares, you might have to pay $50.25 or more. The amount that you drive up the price of something you’re trying to buy is called the “market impact.”
How Does That Impact ETF Trading & How Are ETFs Different?
Because ETFs trade on exchanges like stocks, they have bid/ask spreads, volumes and potential market impact, too. All else equal, you’ll do better trading something that has high volume and a tight bid/ask spread. In this way, trading ETFs is just like trading a stock.
But ETFs have a critical difference that dramatically alters the playing field for investors.
With single stocks, there’s no way to create new shares. But institutional investors called authorized participants (APs) are allowed to create new shares of an ETF to meet demand. So if you want to buy a lot of an ETF … say, 50,000 shares … an AP might create those shares to fill your order.