Investors who once preferred mutual funds are now using exchange-traded funds (ETFs). Whereas mutual funds are bought and sold at the end of the day, ETFs are traded on stock exchanges from the opening to the close. That’s good, but since ETFs trade like stocks it is important to use limit orders. Here’s why:
Limit orders place rules on the price at which you are willing to buy or sell a security. For example, a buy limit order is used to purchase an ETF or a stock at or below a specific price. Along the same lines, a sell limit order is only executed if the trade occurs at or above your specified price.
Limit orders are especially important during volatile markets or if the security is thinly traded. In volatile markets investors who place a market order (the default on most trading platforms) might have the trade filled far from the expected price. In extreme cases such as the “flash crash,” investors who placed market sell orders had their trades executed well below the price they were expecting.
There is a bid and an ask price for every stock and ETF. It works well to place a limit buy order on the ask price or a limit sell order on the bid. You can also save some money by placing the limit order between the bid and ask price. Of course there is no guarantee that the order will be filled.
If there is a large spread between the bid and the ask price then it is likely that the security is lightly traded. For example, the EG Shares India Consumer ETF (INCO) can have a bid-to-ask spread of 0.6 percent and with less than 1000 shares traded a day. If you use a market order you could adversely move the price of the ETF. Here, limit orders are essential.
Limit orders are not needed for some of the most heavily traded ETFs like the S&P 500 SPDR (SPY) and iShares Russell 2000 (IWM). For most others, however, it’s best to use limit orders. That way there will be no surprises when you see your trade executions.
David Vomund is an Incline Village-based fee-only money manager. Information is found at www.ETFportfolios.net or by calling 775-832-8555. Clients hold the positions mentioned in this article. Past performance does not guarantee future results. Consult your financial adviser before purchasing any security.