Price or speed—which element should investors prioritize when it comes to trading ETFs? There isn’t a definitive answer to this question, but a firm grasp of the difference between market orders and limit orders could pave the way to better decisions.
Two ways to trade ETFs
To many investors, the beauty of investing in an exchange-traded fund (ETF) is that it trades like a stock; investors can buy or sell ETFs any time during trading hours, unlike mutual funds, which can only be purchased or sold after their net asset value has been determined at the end of the trading day. In a sense, ETF trading offers an immediacy that complements life in the digital age, which is perhaps one of many reasons behind their popularity.
There’re two ways investors can trade ETFs: by placing either a market order or a limit order. The main difference between the two is the price at which the trade will be executed.
In the case of market orders, investors simply place a buy or sell order with their brokers, and the trade will be executed at a price determined by the market at that moment. It’s useful to remember that market orders typically prioritize order fulfilment over the price at which the trades are executed. This means trades can be executed quickly, but investors have no control over execution price.
This is why ETF investors are often advised against placing market orders—they can end up paying more for their purchases than they had intended to or, conversely, selling their ETFs at a lower price than they had meant to. Limit orders can help investors to avoid that; investors can specify the price range (a minimum price and a maximum price) within which they wish to trade. If prices move beyond the specified range, their trades will not be executed. This can be a useful way to protect ETF investors against poor trade execution. However, the protection comes at a price: speed. If speed is indeed the top priority, a market order might be more appropriate.
Factors to bear in mind
Generally speaking, there are several factors that investors might find handy when thinking about executing ETF trades:
- Liquidity. Unsurprisingly, it’s much easier to trade a liquid ETF than one that’s relatively illiquid. An indicator that can be used to gauge ETF liquidity is the bid/offer spread. The bid is the highest price that buyers are willing to pay for an ETF, while the offer is the lowest price that sellers are willing to accept—the bid/offer spread is simply the difference between the two. Typically, the more liquid the ETF, the smaller the bid/offer spread will be. This is why large ETFs that cover popular indexes such as the S&P 500 Index tend to have tighter bid/offer spreads relative to their more exotic peers.
- Timing. It’s not uncommon to come across advice urging ETF investors to refrain from buying or selling in the first 30 minutes of the trading day. This is when financial markets get their first opportunity to react to overnight news developments such as an earnings report or deal announcement. No surprise then, that the markets—and, therefore, ETF prices—can be somewhat volatile right out of the gate. Logic suggests it makes sense to give markets a chance to settle before making that call to the broker.
- Cost of trading. There’s nearly always a cost associated with trading, and ETFs are no exception. Although the costs involved are typically lower compared with buying and selling stocks, it’s still an expense that will eat into any potential gain and exacerbate potential losses. Investors can keep a lid on these costs by limiting how often they trade and by choosing a broker that best suits their trading habits. ETF investors may also want to bear in mind that trading costs can depend on the underlying asset as well—for instance, trading derivatives-based ETFs can incur higher charges than their index-based cousins.
The bottom line
Just because investors can trade ETFs like a normal stock doesn’t mean they should. It’s important for investors to appreciate the difference between a market order and a limit order, and understand why one trading method might make more sense in some instances but not others—context and perspective can sometimes tip potential losses into gains.
Want to find out more? Check out our Investing basics page. Your financial advisor can help you determine if ETFs are a good fit for your portfolio, and how investing in them might align with your financial goals.