As you get acquainted with exchange traded funds (ETFs), one of the first characteristics of an ETF you’ve noticed is that they are traded like stocks. Like stocks, the price of an ETF changes throughout the day, and determining when you buy and the price at which you buy will in large part be determined by the bid-ask.
What It Is
The spread, or the difference between the bid and ask price of the security, is determined by the basic fundamentals of supply and demand. More buyers means more bids, and more sellers means more asks.
At times, the bid and ask prices equalize, but only for a brief window. All other times, the ask usually exceeds the bid. Hence, the name bid-ask spread.
Highly liquid ETFs tend to have bid-ask spreads of just pennies while more thinly traded ETFs may experience greater disparities. This might pose as one of those hidden costs attributed to trading in ETFs and eat away at potential returns.
The New York Stock Exchange and the Nasdaq match buyers and sellers electronically, but there are some specialists who may also post bids or offers that are slightly narrower than that of the market to maintain a smoother market.
Coping with Wide Spreads
What happens when you’re faced with a wide spread? One option you have is to be patient and wait for the spread to narrow before placing your order, but oftentimes, waiting can cost you if the market is quickly moving in one direction or another. There are other more realistic and efficient ways you can control the price you pay and narrow the bid-ask.
Your options are to place a market order, limit order, good ‘til canceled order, immediate or cancel oder, or stop order with a specialist/market maker.
- Market Order. Orders of this nature are filled immediately at the price when your order hits the market. It should be noted that if an individual places a large order without enough buyers/sellers, the order will be filled at the next price available, which may not be close to what you expected.
- Limit Order. This type of order only sells or buys a certain amount of stock at a certain price you specify, or better. If the whole order can not be fulfilled by a single trade, the order will stand until shares can be traded at the set price, or better.
- Good ‘Til Cancel. When this limit order is placed, it remains in place until either the trade goes through or you cancel the order.
- Immediate or Cancel. These limit orders must be filled immediately, or not be filled at all.
- Stop Order. When a stock hits a certain point, a stop order is executed. If a stock drops to a predetermined set point, the shares are sold and are treated as a market order. It should be noted that it is not guaranteed that the order will be executed in its entirety on your set point since it becomes a market order.
Limit orders are usually best when trading so as to ensure the optimal execution on trades. Limit orders help you maintain control on how and when you trade, which is highly recommended during times of low volume trading.
Your final option if an ETF has a wide bid-ask is to use the services of your brokerage or an alternate liquidity providers. These desks have access to market makers who can create shares of that ETF in order to narrow the spreads.
It should also be noted that bid-ask spreads increase for large orders, and the spreads are more noticeable for thinly traded stocks. Large orders need higher buying prices and lower selling prices to be fulfilled.