When Trading ETFs, Don't Forget Your Fundamentals | ETF Trends

The U.S. exchange traded funds industry is nearly three decades old, but some sage advice still rings true today, including the use of limit orders when trading ETFs.

Limit orders are trades that specifically state how many shares are bought or sold at a specific price or better. For instance, a buy limit order can purchase an ETF at or below a stated price, and a sell limit order can only be executed at the limit price or higher. Traders should also be aware that limit orders may cost more than market orders.

“Investors tend to use market orders in instances where time is of the essence and price is of secondary importance. Investors using market orders want to execute their entire order as soon as possible,” notes Morningstar’s Ben Johnson. “For very large, very liquid ETFs that trade contemporaneously with their underlying securities, like SPDR S&P 500 ETF (SPY), market orders will likely result in fast execution at a good price. But most of the 2,400-plus exchange-traded products on the market are smaller and less liquid than SPY and its ilk and may also trade out of sync with their constituent securities.”

While limit orders do not guarantee execution, ETF investors should utilize them when buying or selling an investments. This way the investor never pays more than he or she intended.

In comparison, typical market orders would execute a buy or sell order at the best available price. This may not implement trades on prices originally quoted. During times of high market volatility, the price discrepancies are especially noticeable. particularly with securities in low volume trades.

Different Ways to Purchase ETFs

Exchange traded funds are listed on an exchange and trade like any common stock. Consequently, investors should also utilize limit orders to better control and execute trades, diminishing the risk of any unwanted surprises.

When purchasing or selling ETFs through a brokerage account, investors can choose among several order types, such as a market order or a limit order. The options also apply to stop-loss orders that trigger an automatic sell when an ETF dips to a certain price.

However, investors should understand the differences between the order types. A market order is designed to fill immediately at the best available current price, and the price at which the order was placed is not guaranteed.

“In all cases, using limit orders is good practice. Limit orders will ensure favorable execution from a price perspective,” adds Johnson. “A buy limit order will fetch the buyer a price less than or equal to the limit price, while a sell limit order will transact at a price greater than or equal to the limit price.”

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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.