By following a few best practices, you can help ensure favorable prices for your ETF trades.
Limit orders let you determine the maximum or minimum price at which you'll execute an ETF trade. While limit orders offer you control over price, there is always some risk that your order won't be fully executed.
Market orders can be effective when you're buying or selling ETFs with significant liquidity and narrow spreads. However, since the overriding objective of a market order is trade execution rather than price protection, it's possible you will receive an undesirable price for your trade.
Be wary during volatile periods or when there are major events that affect markets. Market volatility can cause the prices of an ETF's underlying securities to move sharply, which can in turn cause the ETF's shares to have wider bid-ask spreads or larger premiums or discounts. Limit orders may be beneficial in such situations because of the price protection they provide.
Investors should pay attention to market news as ETF prices may swing in response to the release of economic indicators or statements from central banks, as well as earnings and other news from companies that are large constituents of an ETF.
A common misconception is that ETFs with lower average daily volume (ADV) are not as liquid as other ETFs in the marketplace. ADV is generally a good gauge of liquidity for a single stock because the number of its outstanding shares is generally fixed. However, ETF shares can be created or redeemed through an authorized participant, so the liquidity of the ETF's underlying securities is what matters most. When the underlying securities are difficult to trade, it can result in a wider bid-ask spread for the ETF. Learn more.
Spreads can widen at certain times each day or on certain days of the year.
At market open, some of an ETF's underlying securities may not have begun trading, which means a market maker can't price the ETF with certainty.
At market close, fewer firms may make markets in an ETF as market participants try to limit their risk, so fewer shares may be listed for purchase and sale than at other times of the day. When international markets are closed, spreads can widen for ETFs in Mexico that invest primarily in securities that trade on exchanges overseas. If you're trading an ETF that invests internationally, know the market holidays of the relevant overseas exchanges.
Use a block desk. A block desk, if one is available to you, can use various trading tools to help you source liquidity for a large order.
In general, it's better to trade international ETFs when the underlying local markets are open. Because ETF values are based on the prices of their underlying securities, the prices of international ETFs tend to be closer to their real-time NAVs when their respective markets are open. For example, if you're trading an ETF that invests in European securities, you often will see narrower spreads and/or premiums/discounts and prices closer to real-time NAVs during the morning trading hours in Mexico, when the underlying securities are still trading in their local markets, versus the afternoon trading hours, when the local markets are closed.
Source: Vanguard. The graphic is shown for illustrative purposes only and shall not be construed as a recommendation to buy or sell any security or financial instrument, or an offer or recommendation to participate in any particular trading or investment strategy.
The ETF market is actually made up of two markets–a primary market where ETF shares are created and redeemed, and a secondary market where ETF shares trade on an exchange.
ETF managers (for example, Vanguard) manage the ETF and its portfolio of securities.
Authorized participants are institutions that interact directly with an ETF manager to create and redeem large blocks of ETF shares.
Market makers provide intraday liquidity for securities on the stock exchange. They compete for orders by publishing bid and ask quotes for a number of shares.
Lead market makers are assigned to ETF products listed on an exchange. The lead market maker has certain quote, trading and other service obligations set by the exchange and receives incentives for meeting those obligations.
Block-desk traders help ensure that large ETF trades are executed efficiently. When executing ETF block trades, they are able to find liquidity in an ETF regardless of its average daily volume or the liquidity shown on the trading screen.
Investors buy and sell ETF shares on an exchange at an agreed-upon price.
It's a common misconception that an ETF's liquidity is best gauged by its average daily volume (ADV).
The reality is more complex. That's because ETFs get most of their liquidity from sources other than their trading activity on the stock exchange. Most important of these is the liquidity from an ETF's underlying portfolio of securities. The main sources of ETF liquidity are:
The most visible source of ETF liquidity is the trading activity of buyers and sellers in the secondary market that takes place on an exchange. Trading volume is a measure of this activity, but it doesn't indicate an ETF's total liquidity.
The natural liquidity of ETFs trading in the secondary market is enhanced by exchange-registered traders called market makers. Market makers help maintain a fair and orderly market by selling ETF shares to potential buyers and by buying ETF shares from potential sellers.
Not all of an ETF's liquidity in the secondary market is easy to see. If you're a typical investor, your "on screen" view is probably limited to what's available through public financial websites. This means you'll have access to an ETF's highest bid and lowest ask, but you won't be able to see all the quotes in an ETF's order book. These quotes are another source of ETF liquidity because they represent additional prices at which ETF shares can be traded.
The key to ETF liquidity lies in ETFs' open-ended structure. Unlike single stocks, which generally have a fixed supply of shares, new ETF shares can be created and existing shares redeemed based on investor demand. This unique process allows ETFs to access the liquidity of their underlying securities. The result is that investors can often trade ETFs in amounts that far exceed an ETF's ADV, without significantly affecting the ETF's price.
ETFs allow you to place any type of trade that you would with stocks. Here are some common order types:
You buy or sell immediately at the best available current price. When you place a market order, your priority is making the trade quickly, not securing a particular price.
You set a price—the stop price—at which you automatically buy or sell. When the market hits the stop price, your stop order becomes a market order. The price you then get is the best available current price. That price may have changed, for better or worse, in the moments after your stop price triggered your market order. When you place a stop order, your priority is trying to limit a loss or protect a profit.
You set a price and execute your trade only if shares are available at that price or better. Limit orders protect you from executing a trade at an undesirable price. When you place a limit order, your priority is securing a certain price, not speed of execution.
Similar to a stop order, but in addition to setting the stop price, you also set a limit price. When the market hits the stop price your stop order becomes a limit order, at the limit price you specified. When you place a stop-limit order, your priority is trying to limit a loss or protect a profit without the unpredictability of a market order.
A number of factors can influence how you place ETF orders and when you should call a block desk for assistance.
You want to execute your trade right away
Whether you want to lock in a current market price, avoid adverse market movements or simply execute your daily trades and move on to other priorities, the key to determining your trading approach is understanding the effect of trading volume.
If the ETF you want to trade has a high average daily volume (ADV) you can execute a simple limit order through your trading site. However, when you want to place an order for an ETF with a low ADV, it may be better to call your block desk. Ask for a market order from your block-desk representative for the number of shares you want to trade, and he or she will provide bid and ask prices for the trade size.
Keep in mind that your block desk has access to an extensive network of liquidity providers that can help place your order and execute your trade, especially in low-volume situations.
You want to work an order over time
When your objective is to place an order for the best possible average trade price over a period of time and the ETF in question is trading at a high ADV, your best option is to have the block desk work the ETF order.
When your objective is the same, but the ETF is trading at a low ADV, your block desk can assist with more sophisticated order and execution strategies, including:
TWAP and VWAP orders ensure your trade will be executed not at the lowest or the highest price but at an average of the two during the specified period of time.