5 Tips for Trading ETFs

Best practices for avoiding unnecessary trading costs.

Bryan Armour 4 April, 2024 | 4:48AM
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The tradability of exchange-traded funds is often touted as one of their advantages over mutual funds. ETFs trade throughout the day, much like common stocks, while investors can only buy or sell mutual fund shares once per day. Investors can benefit from the flexibility afforded by ETFs, especially when trading popular ones with tight bid-ask spreads and substantial liquidity. But most ETFs on the market don’t capture much attention and can be a challenge to trade efficiently. As of December 2022, over 1,000 ETFs traded less than 10,000 shares per day on average. Crossing bid-ask spreads in these ETFs can take significant chunks out of future performance.

Illiquid markets aren’t the only reason for caution when trading ETFs. The market mechanisms underpinning ETFs have experienced hiccups of varying magnitude, ranging from the flash crash in 2010 and the meltdown around the market open on Aug. 24, 2015, to more sporadic episodes of lesser impact. These events serve as a reminder of why investors should exercise caution and enlist best practices when buying and selling ETF shares.

Investors can safely and efficiently trade ETFs if they abide by these five tips on how best to trade ETFs.

1) Use Limit Orders

I spent a combined 14 years as a trader and regulator of ETF trading activity. That experience taught me that limit orders are the number-one way to prevent a bad trade. Investors typically have two options for submitting orders: market orders and limit orders. Market orders execute a buy order almost instantaneously at increasing prices until the entire order quantity is filled (or decreasing prices for a sell order). Limit orders, on the other hand, allow investors to choose a maximum price at which they will accept a trade.

For very large and liquid ETFs that trade contemporaneously with their underlying securities, like SPDR S&P 500 ETF SPY, market orders will likely result in fast execution at a good price. But most of the 3,000 exchange-traded products on the market are smaller and less liquid than SPY and similar highly popular ETFs, so trades won’t necessarily get executed at reasonable prices

In all cases, using limit orders is good practice. If time is of the essence, use an aggressively priced limit order (that is, set the limit price of a buy order above the current offer price). The only potential cost of using limit orders is an incomplete execution. It may take longer for a limit order to be filled than a market order, or the market could move away from the order’s limit price, leaving it unfilled. These costs need to be weighed against the cost of being exploited by an opportunistic market maker looking to pick off market orders in thinly traded ETFs—an occurrence that is all too common.

2) Trade When the Underlying Market Is Open

In recent years, cryptocurrency markets have touted their 24/7 trading hours, and a few brokerage firms have added night trading of popular ETFs for its customers. While customers may like having the option to unload all their bitcoin in the middle of the night, liquidity is significantly better at certain times than others. For Canadian and U.S. ETFs, significantly more liquidity becomes available for investors during Canadian and U.S. market hours.

If you are trading an ETF that invests in securities that trade in markets outside Canada and the United States, it’s best to trade when the ETF’s constituents are actively changing hands in their home market. For example, it would be best to trade Vanguard FTSE Europe ETF VGK during the morning while European markets are still open. It’s easier for market makers to keep ETFs in line with their underlying stocks when they’re being bought and sold in real time across Europe. Once European markets close, market makers rely on the fluctuations of Canadian and U.S. market as a guide in setting prices, which is inherently less reliable.

3) Don’t Trade Near the Open—or the Close, for That Matter

The stock market takes some time to “wake up” after the opening bell. Since most participants operate during normal market hours, the opening auction and shortly thereafter is a time for price discovery—a fancy term for the jousting that occurs when incorporating all the orders and investing decisions made by participants since the prior close. Market makers play it safe during this time: The more volatile the market, the wider their spreads.

As price discovery works out its kinks and bid-ask spreads coalesce around prices for stocks, market makers can more accurately price ETFs. This leads to tighter spreads and more liquidity, making it the ideal time to trade ETFs. That is, until the closing bell approaches. As the market winds down toward day’s end, many market makers widen their quotes to limit their risk headed into the close. Closing auctions are where the action is, and participants don’t want to get stuck with a bad trade right before the closing price is struck. As a result, spreads tend to widen as Canadian and U.S. markets approach the close.

In light of these considerations, it makes sense to wait about 15 minutes after the opening bell to trade an ETF and to avoid trading during the 15 minutes leading into the market’s close.

4) If You’re Making a Big Trade, Phone a Friend

For investors looking to execute a large trade in an ETF, it makes sense to engage the help of a professional. There is no hard-and-fast definition as to what qualifies as a large trade. General rules of thumb would place any trade that accounts for 20% of an ETF’s average daily volume or more than 1% of its assets under management as fitting this description. In these cases, investors can potentially save themselves substantial execution costs at the expense of spending some time on the phone with your broker, a representative of an ETF provider’s capital markets team, and/or a market maker.

Investors have a couple of options when going this route. Block trades allow investors to make a large trade at a single price. But that trade can occur outside of the bid-ask spread in many circumstances. Alternatively, trading algorithms can source liquidity over longer time frames (that is, over the course of a day) while minimizing the price impact of the large order. The facts and circumstances of the prospective trade will ultimately dictate which option would best serve the investor.

5) If Trading Isn’t for You, Buy a Mutual Fund

ETFs aren’t for everyone. With investment minimums for many index mutual funds and ETF trading commissions having been zeroed out in recent years, the choice between an ETF and an index fund that track identical benchmarks can now be boiled down to personal preference and circumstance. If you place no value on intraday liquidity, and you would prefer to forgo navigating the ins and outs of ETF trading, then an index mutual fund tracking the same benchmark is likely a better choice for you.

 

A version of this article was published on Dec. 22, 2022. The author or authors do not own shares in any securities mentioned in this article.

 

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About Author

Bryan Armour  is director of passive strategies research for North America at Morningstar. Before joining Morningstar in 2021, Armour spent seven years working for the Financial Industry Regulatory Authority, conducting regulatory trade surveillance and investigations, specializing in exchange-traded funds. Prior to Finra, he worked for a proprietary trading firm as an options trader at the Chicago Mercantile Exchange.

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