3 things to remember when trading ETFs
EFinance funds have lowered the barriers to entry for the investment industry. Assets that were previously considered off-limits or at best beyond the reach of retail investors are now easily accessible. In other words, you don’t have to be a seasoned stockbroker or a venerable institutional investor to trade these vehicles.
But as simple as ETF trading is, there are still a lot of moving parts, and some things can still be easily overlooked or forgotten.
With that in mind, here are three things to consider when trading ETFs:
Make sure the market is open
Consider this: if you buy an ETF on the New York Stock Exchange that holds positions in foreign stocks, are you making that transaction when those stocks are trading? Asking if the underlying market you are looking to access is open for trading is a question that investors often overlook when buying a position, especially when trading ETFs that offer exposure to stocks, commodities or foreign currency. Forgetting this could cost you money.
Dave Nadig, Research Director at ETF Trends, explains that when trading, particularly in terms of size, the on-screen price you see is heavily influenced by how easily an Authorized Participant (AP) can buy. or sell the basket of securities it needs to interact with the issuer. But if the basket is not trading, the AP cannot effectively enter a trade to correct prices to fair value.
“If you buy a Japanese ETF in the US, the AP literally can’t do a creation,” Nadig says. “They could sell you 50,000 shares of the ETF, but they have to wait until tonight to buy the underlying shares. This introduces risk to their profit, so they ‘charge more’ just by allowing spreads to widen, or allowing trading pressure to deviate from “fair value” more than you think.
So remember: European stocks traded on Euronext are open until 10:30 a.m. EST, while the London Stock Exchange is open until 11:20 a.m. EST. Stocks traded in Australia, China and Japan do not overlap Wall Street trading hours. Meanwhile, for commodity traders, metals futures on the Comex Metals Exchange are traded from 8:20 a.m. to 1:30 p.m. EST, and grain futures on the Chicago Board of Trade are traded 10:30 a.m. to 2:15 p.m. EST.
Consider the spreads and learn to love limit orders
When looking at an ETF quote, look at the “bid” and “ask” prices. The auction price is the highest advertised price you can currently get as a seller. Likewise, the asking price is the lowest advertised price you can pay if you are looking to buy.
For your next trade, consider placing your limit order somewhere inside the bid-ask spread. This way, you may be able to reduce trading costs by getting a better deal on the price at which you bought or sold.
“Every time you enter a market order, you’re actually saying, ‘I don’t really care about the price, but I care a LOT about how fast this is executed,'” Nadig explains. “It’s a recipe for poor execution. With a limit order, you’re saying, “This price or better, I’ll wait.” And you can choose a price that is even a little worse than what the market might say.
For example, if the bid is $40.20 and the ask is $40.40, try placing your buy limit order at $40.25 and see if you can get filled at a lower price than the one announced.
“Keep in mind that volatile markets can also bring uncertainty to ETF pricing,” notes advice from American Century Investments. “Market fluctuations can cause the prices of the underlying securities to fluctuate sharply, resulting in wider bid/ask spreads or higher premiums and discounts for the ETF.”
Be aware of distribution dates
Although ETFs are designed as tax-efficient vehicles, unexpected tax distributions can sometimes have significant consequences. For example, leveraged and short-term ETFs can generate notable short-term capital gains if the value of the underlying derivative contracts skyrockets and there is a massive shareholder redemption.
Such a scenario would in turn force the fund manager to sell the positions and pass the gains on to the remaining shareholders. As such, large tax liability events can certainly lead to volatile trading for some ETFs.
As Nadig notes, you don’t want to buy an ETF at $100 on Monday and then find it is trading “ex-dividend” on Tuesday down $10. “You don’t lose the $10, a few days later you receive the dividend in your brokerage account, but then you have to deal with tracking the cost base and possibly pay taxes on the dividends you’ve only held for one day,” he says. “While technically it’s not a huge issue, it loses a timing option, especially when it comes to taxes.”
So be aware of upcoming tax distribution dates for the ETFs you own. It’s also a good idea to keep an eye out for any large outstanding tax liabilities on the funds you’re looking to buy, as you may be able to get a better price after the distribution record date.
For more news, insights, and strategies, visit the Core Strategies channel.
Learn more at ETFtrends.com.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.