Caution: Use Limit Orders with ETFs

November 3rd at 7:00am by Tom Lydon

One of the things investors and traders like about ETFs is the ability to buy and sell during the day. However, investors need to be careful when trading ETFs to make sure they don’t get hurt by bid-ask spreads or deviations from fair value, especially in unsettled markets.

When buying or selling ETFs through a broker, investors can use a market order or a limit order. The choice also applies when investors are setting up stop-loss orders that trigger an automatic sell when an ETF falls to a certain price.

A market order is designed to fill immediately at the best available current price. As the SEC’s website explains, the price at which a market order will be executed is not guaranteed.

“It is important for investors to remember that the last-traded price is not necessarily the price at which a market order will be executed. In fast-moving markets, the price at which a market order will execute often deviates from the last-traded price or ‘real time’ quote,” the SEC notes.

A limit order, however, is designed to fill at a specific price or better, and is not guaranteed to execute at the order price, although that’s not necessarily a bad thing. [Protecting Your ETF Trades]

The 2010 Flash Crash and the Knight debacle this summer are reminders that the difference between market and limit orders is important to ETF investors and traders. [Five Lessons for ETF Investors After the Knight Meltdown]

Last week, in the aftermath of Hurricane Sandy, Knight Capital (NYSE: KCG) announced Wednesday that its backup power generation system had failed, leading the firm to shut down all trading and direct orders to other brokerage firms for several hours, Morningstar reports.

Knight is an important market maker in ETFs that helps provide liquidity and keep trading spreads as narrow as possible.

“While Knight is the lead market maker for ETFs, there are other firms out there that can pick up the slack (and have done so),” writes Morningstar’s Robert Goldsborough.

“Given the shaky power situation right now in the New York/New Jersey region, we recommend that investors avoid using market orders when buying ETFs. Instead, investors should watch a fund’s bid-ask spreads closely and use limit orders only,” he added. “Some of these same concerns apply to stock investors, but we believe they are far more pertinent to ETF investors, since market makers are so critical to the way that ETFs come to market.”

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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