Buying and selling an ETF is pretty straightforward. However, ETF transactions aren’t quite as simple as placing a buy or sell order. Following these three trading tips should allow you to trade ETFs more efficiently and avoid some common trading problems.
Always use a limit order
An ETF’s fair value or net asset value (NAV) is tracked throughout the day by a market maker. The market maker’s function is to ensure that the bid and ask prices for the ETF constantly tracks closely to the NAV throughout the trading day so that buy and sell orders can be executed efficiently regardless of trading volume. However, the market making system is automated and sometimes can experience interruptions where the market maker is not “in” the market to ensure efficient pricing. When this happens, the market maker’s bid and ask prices disappear and the prevailing bid and ask prices at that time are those of other market participants that may not be closely tracking the current NAV. By using a limit order, you can specify the price for buying or selling units/shares and limit the length of time the order is valid before being cancelled.
TIP – consult the ETF provider’s website to determine the previous day’s closing NAV on the ETF you are interested in. This will provide you with a good benchmark as to where the ETF’s NAV should be and where to put in your limit order. If you have access to level 2 depth of market quotes, look for the bid and the offer where there is the most amount of “size” quoted, and place your limit order there.
Avoid trading in the first and last five minutes of the trading day
An ETF is a convenient way to buy a diversified basket or portfolio of securities. The price of the ETF is simply the weighted average price of each of the underlying securities. However, when the market opens, it may take a few minutes for some of these underlying securities to begin trading and have their value reflected in the price of the ETF. At the end of the day, the market maker that keeps an ETF’s value in line with its NAV may be out of the market as it is executing its own closing transactions.
Only execute ETF trades when the underlying market is open
This is particularly important when executing trades in an ETF that tracks a commodity or currency. Commodity and currency markets open and close at different times than North American equity markets which are open from 9:30 a.m. EST – 4:00 p.m. EST. Because ETFs are listed on an equity exchange, it will trade during these times, even though the underlying commodity or currency market could be closed. In order to ensure that you are getting fair pricing to NAV, it is generally best to buy and sell the ETF when the underlying market is open as that’s when the market maker can ensure accurate pricing. Consult the ETF provider’s website for the times that the underlying commodity or currency market is open. This also applies to holidays when a Canadian market might be open and the U.S. market might be closed.