Just because exchange traded funds can be bought and sold while markets are open doesn’t mean investors should be day-trading with ETFs. Furthermore, individuals need to understand how liquidity, bid/ask spreads, and premiums and discounts can factor into total costs when trading ETFs.
If you are considering incorporating ETFs into an investment portfolio, you might want to consider these points before taking on the trade:
- Trading on Demand. Unlike traditional mutual funds, ETFs can be traded intra-daily on an exchange like a regular stock. Traders can follow the direction of the market and take advantage of short-term movements during the trading day.
- The Spread. The bid/asks spread is the difference between the bidding or asking price of a particular stock. Wider bid/ask spreads may eat away at potential returns on an investment, which may be more noticeable if you are a day trader as opposed to a buy-and-hold investor. [What You Should Know About ETF Bid/Ask Spreads]
- Cost of Trading. For the buy-and-hold minded investor, the expense ratio would be the main cost consideration – the lower the expense ratio the less amount of money is paid out as management fees in the long run. However, day traders should be more focused on commission fees for quick market trades. Some brokerages offer commission-free trades on a number of ETF products. [E-Trade Rolls Out Commission-Free Trades on 93 ETFs]
- Know Your Orders. The standard market order is placed at the current market price, which you have no control over – a trader’s order will go through, but the price may not be the original quoted price. This type of order is particularly nasty during times of high volatility when market prices make large swings. Instead, using limit orders will help an investor take control of a trade by ensuring that you are never paying more than you specified.
- Monitor the NAV. The net asset value (NAV) determined from the value of all securities in the portfolio divided by number of outstanding shares. The NAV is important since the market price of an ETF is determined by its underlying shares. When the ETF’s price is lower than the NAV, the ETF is said to be at a “discount.” If the ETF’s price is above the NAV, the ETF is said to trade at a “premium.” [Three Things to Remember About ETF Premiums and Discounts]
For more information on ETFs, visit out ETF 101 category.
Max Chen contributed to this article.
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.