• ETF Insights

    ETF 104: Getting the Most Out of Your ETF Trades

    07 October 2019
     

    By sticking to some important trading best practices, investors can ensure they are executing trades in the most cost-efficient manner possible.

    ETF 101: Understanding the Basics
    ETF 102: The Inner Workings of ETF Creations and Redemptions
    ETF 103: Is This ETF Right for Your Portfolio?
    ETF 104: Getting the Most Out of Your ETF Trades
    ETF 105: Gaining Efficient Access to Bond Markets with Fixed Income ETFs

    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.

    Figure 1: Market Makers and the Secondary Market

    Total
    Size
    Size Bid   Ask Size Total
    Size
    100 100 $22.21      $22.23           100           100
    2,500 2,400 $22.07   $22.28 2,400 2,500
    2,700 200 $22.05   $22.29 200 2,700
    2,900 200 $22.02   $22.31 200 2,900
    5,300 2,400 $22.00   $22.34 2,400 5,300
    5,500 200 $21.95   $22.35 200 5,500
    5,600 100 $21.90   $22.40 2,400 7,900
    5,700 100 $21.85   $22.42 200 8,100
    5,800 100 $21.80   $22.50 1,900 10,000

    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 familiarise yourself with the different ways trades can be executed. Four of the most common order types are summarised in Figure 2 below.

    Figure 2: Order Types: Market, Limit, Stop, Stop-Limit Orders

    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 characterised 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 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 characterised by heightened stock volatility, wider spreads, and weaker liquidity. Afterwards, spreads tend to normalise and remain relatively stable for much of the remainder of the trading day.

    The World on Time: Overseas Markets and International ETFs

    Broad-based ETFs invest in securities that trade globally. Spreads on ETFs that hold these securities will be at their best when a majority of the underlying markets are open. Market makers can price ETFs with more certainty when the ETF and all or most of its underlying markets are trading, so look for spreads to widen if one or more of the markets that make up an index are on holiday or closed when the ETF is trading in Europe.

    For example, a US ETF (a fund with exposure to US markets) trading on a European exchange will trade better with a tighter spread later in the day when US markets open. 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 the underlying markets are closed.

    To help ensure more cost-effective trades in 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 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 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 characterised 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 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.

    VanEck UCITS ETFs are available to trade in USD, GBP, EUR and CHF currencies on various European exchanges. For more information, please reference the relevant fact sheet or ETF page.

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    [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).