By sticking to some important trading best practices, investors can ensure they are executing trades in the most cost-efficient manner possible.
An Overview of the Secondary Market
To understand why some orders can deliver better trading outcomes than others, you need to understand the mechanics of the
secondary market. The secondary market serves as an initial layer of liquidity where investors buy and sell shares of ETFs. The primary market is an additional source of liquidity where in some instances, large blocks of certain ETF shares are created and redeemed. Primary market transactions may be triggered by a surplus in supply or demand for ETF shares.
Market makers maintain order in financial markets by acting as intermediaries between buyers and sellers on exchanges. In the secondary market, for every individual security, market makers post
bids, or the prices they are willing to pay to buy the security, and offers (also known as “asks”), or the prices at which they are willing to sell the security. The difference between the bid and the offer is known as the
bid-offer spread[1].
For any given ETF, there are typically multiple market makers in the secondary market, posting multiple “layers” of bids and offers with specific sizes. Market makers usually refrain from posting outsized large bid/offer share sizes for a variety of reasons – one of which is capital constraints. However, the definition of “outsized” will vary from product to product depending on its secondary market liquidity. The resulting bids and order create an order book which may look something like Figure 1.
Market makers on the secondary market post differently sized offers at a variety of prices.
Use Limit Orders and Avoid Market Orders: What’s the Difference?
An important first step in getting the most out of ETF trades is to familiarize yourself with the different ways trades can be executed. Four of the most common order types are summarized in Figure 2 below.
Figure 2: Order Types: Market, Limit, Stop, Stop-Limit Orders
Generally speaking, investors should use limit orders whenever possible instead of market orders. This is because limit orders offer greater price control, which can result in more cost-effective trades.
Referring to the order book in Figure 1 on the previous page, it quickly becomes apparent why a market order may not provide the most cost-efficient trade. A market order to buy 10,000 shares of this ETF would execute 100 shares at $22.23 (leaving 9,900 shares left to purchase), 2,400 shares at $22.28, 200 shares at $22.29, and so on down the list of available layers of liquidity until the entire order is filled, at a much higher average purchase price than the lowest ask/offer. The weighted average price for a trade executed via a market order would be $22.37, which is 63bps worse than the top layer of the book. Even though the top layer shows a $0.02 bid-offer spread, which may appear tight, notice the lack of “depth”, or shares behind those quotes – another element to be mindful of as it relates to a fund’s secondary market trading.
This is where one can see some of the benefits of limit orders. Imagine that instead of placing a market order, an investor placed a
limit buy order for 10,000 shares at $22.24 (4.5bps of impact) for the same ETF as in the first example. The first 100 shares of the order would immediately execute, leaving 9,900 shares remaining. Market makers would then have more time to complete the order at the limit order’s specified price, which may result in a lower average purchase price for the investor. In many instances, there may be additional liquidity available that a market maker chose not to display. Limit orders may give market makers a chance to post additional liquidity at the buyer’s limit price which in turn provides more control over the execution price for the buyer.
Pay Attention: Monitoring Market Conditions
To help ensure a more cost-efficient ETF trading experience, it’s important to pay close attention to overall market conditions. The behavior of futures markets before the market opens can be a helpful indicator of what lies ahead in terms of volatility. On days characterized by significant volatility, exercise caution as heightened volatility usually results in wider bid-offer spreads, higher premiums
[2] and discounts
[3], and weaker ETF liquidity.
Keep an Eye on the Clock: Avoid Trading During Certain Times of Day
A lot can happen overnight, which is why ETF investors should generally avoid the first 30-45 minutes of the trading day. Breaking news, market activity, and morning economic releases all contribute to an early period of price discovery after market opening, often characterized by heightened stock volatility, wider spreads, and weaker liquidity. Afterwards, spreads tend to normalize and remain relatively stable for much of the remainder of the trading day.
If possible, investors should also avoid trading during the final hour before the market closes. Although it is one of the most active trading times of the day and frequently sees boosted liquidity, the last hour of trading typically sees heightened volatility as well.
The World on Time: Overseas Markets and International ETFs
International ETFs require special considerations for trading. In general, trading ETFs with international holdings is better done while the corresponding foreign markets are still open and there is more price certainty.
For example, a European ETF (a fund with exposure to European markets) trading on a U.S. exchange will tend to trade better earlier in the day before European markets close. This is because the liquidity of an ETF is usually dependent upon the ability of market makers to price and trade the ETF’s underlying securities, and market makers cannot access these underlying securities immediately when foreign markets are closed. Nevertheless, this doesn’t necessarily mean that international ETFs are less liquid, because market makers are eventually able to trade these securities once foreign markets re-open.
To help ensure more cost-effective trades in international ETFs, investors should avoid volatile trading days, as heightened volatility can increase uncertainty. Investors should also keep an eye out for country-specific news that might cause volatility in a relevant foreign market. Extended holiday closures in foreign markets may also have more substantial impacts on the ability of market makers to trade the ETF’s underlying securities.
Key ETF Trading Takeaways
Sticking to trading best practices can help investors make better decisions about when and how to execute trades. By avoiding certain times of the day, using limit orders instead of market orders, and paying attention to market-moving news, both domestically and in relevant foreign markets, investors stand a better chance of making cost-effective trades at a fair price.
ETF Trading Quick Reference Guide
Pay Attention to Market Conditions
- Futures markets before market opening can be helpful indicators of volatility.
- Use caution when trading on days characterized by significant volatility.
- Market volatility usually results in wider ETF spreads and weaker ETF liquidity.
Use Limit Orders
- Use limit orders; a marketable limit order can be used to help ensure execution.
- With a market order you lose price control; experienced portfolio managers generally trade with limit orders.
- Avoid order types such as market on open (MOO), market on close (MOC), and stop orders.
Avoid Certain Days/Times
- Market Open: Avoid the first 30 minutes of the trading day when ETFs are less liquid and spreads are wider.
- Market Close: Overnight risk could deter some market makers from providing good liquidity.
- Market Closures: International and bond market holidays may impact market makers’ abilities to value associated ETFs as well as create/redeem them.
International ETFs
- ETFs with significant European and Middle Eastern exposure tend to trade better before the foreign markets start to close during the first half of the U.S. trading day.
- During periods characterized by volatility, large orders in international ETFs may have more market impact due to greater risk and less pricing certainty.
IMPORTANT DISCLOSURES
[1] Bid-offer spread: also known as the “bid-ask spread.”
[2] Premium: when an ETF’s share price trades at a higher amount than its net asset value (NAV).
[3] Discount: when an ETF’s share price trades at a lower amount than its net asset value (NAV).
Related:
Exploring Intraday Trading for Investors and CTAs
Related:
The Counter-Trend Trading Program with Thomas Kochanek
