[This article appears in our January 2018 issue of ETFR Report.]
Whether you trade a single ETF share at a time or thousands, how you order trades matters. Three main order types exist: market order, limit order and stop order. Here are the pros and cons of each.
A market order is an order to buy or sell an ETF right now. The order executes immediately, at whatever the best available price may be.
With a market order, speed outranks price. That’s fine for highly liquid, high-volume ETFs, but it can be a recipe for disaster for volatile or less liquid funds.
A limit order establishes a maximum or minimum price at which you’re willing to trade an ETF. The order only executes if the ETF’s share price meets that target (or better). A buy limit order for $5/share, for example, means you’ll only buy if the ETF hits $5 or below.
With limit orders, you can set boundaries over trades to ensure you don’t pay more or receive less for shares than you want. But they aren’t guaranteed to execute. If, per our example, the ETF’s price never falls to $5, then your limit order would never execute and you’d never get your shares.
Still, “a limit order is a good idea any time you’re trading a particularly large size, whether in shares or in market value,” said Blair duQuesnay, chief investment officer and principal of New Orleans-based ThirtyNorth Investments. “You want to make sure the order you’re putting in isn’t going to move the price.”
A stop order is a market order that only activates if the ETF in question reaches a particular price (the “stop price”).
A sell-stop order for $5/share, for example, only activates if the ETF’s share price hits $5, after which your shares then sell for whatever the best available market price may be.
A sell-stop order is sometimes referred to as a “stop loss” order, because using one ostensibly protects your profits from further losses. (However, there’s nothing about a stop-loss order that saves you from losing money due to bad execution.)
Like limit orders, stop orders establish boundaries over what prices you are and aren’t willing to accept. That’s helpful if you can’t or don’t want to track the market minute by minute, but you still need protection from sudden swings.
Keep in mind that your stop price isn’t your trading price. The stop price is just a trigger—once the trade activates, it then becomes a market order.
Furthermore, if an ETF grows volatile, your stop order might trigger before you want it to. This is especially true for illiquid markets, where ETF prices can sometimes drift from net asset value for hours at a time before ultimately correcting.
A stop-limit order combines stop and limit orders in what seems like a very useful automated process. Once an ETF’s share price hits the stop price, the trade activates and is executed as a limit order (meaning, it doesn’t fill until it reaches the limit price or better).
For example, for a sell-stop-limit order with a stop price of $5 and a limit price of $4.50, your order activates as soon as the ETF’s price falls to $5. But your shares are only sold if they’re above $4.50.
That means everything is fine if the price is moving by small increments, like a penny or two, but there are significant potential drawbacks.
If the price drops to $4.49 from $5.00, your order will have been activated by the fall to $5.00 (the stop part), but it won’t fill (the limit part). And if the price is in full-on free fall and it gaps down to, say, $3.00 or even $1.00, your order will not have gone through, and you’ll be left holding shares you probably don’t want.
However, as with a limit order, you may not find someone willing to pay your limit price. Further, ETFs don’t always move incrementally. If the price spikes or plunges, your stop price might be triggered but the limit order might never be filled.
If, in our above example, the ETF price gapped down to $3, the stop-limit order will still activate, but the limit order can’t execute until the ETF’s price rises back above $4.50. Thus, the trade won’t execute—and never will, so long as the ETF stays below $4.50.
Market orders are usually safe if you’re mostly trading large, liquid ETFs. If you want to protect against potential downside risk, however, a limit order is usually safer. And stop orders should always be used with care lest you get caught in an arbitrary pricing movement.