How ETF trading works

Buying and selling ETFs works differently than trading traditional mutual funds. Vanguard investing experts Brian McCarthy and Rich Powers explain some of the terms investors commonly hear and how ETF trading works.


Amy Chain: We’re getting questions more about those, the buy, sell, and order limit terms that we threw around earlier. Brian, can you pause to define some of those for us?

Brian McCarthy: So buy/sell limit, there’s a few different order types, but I guess I’ll just start with the limits since that’s a question. So a buy/sell, a buy limit or a sell limit is when the customer or the investor has taken complete control of the price that they’re willing to achieve in the market. So you’re guaranteed that that’s a price you’re going to receive if someone’s—

Amy Chain: I’m willing to pay $1, and I will only pay $1.

Brian McCarthy: Right, but then you have to make sure that someone’s willing to sell at $1. So you’re guaranteed the price, but you’re just not guaranteed of an execution. The other type of order that’s frequently contrasted with limit orders are market orders. So in a market order, if you see a quote in the marketplace and you say, “I want to buy it at market,” similar to going to a marketplace, right, you’re buying it, that current price as it is available in the marketplace.

Amy Chain: Like when you want to get lobster at a restaurant, and it says “MP,” and you don’t know what you’re going to pay, but you’re willing to pay it if you want that lobster. Is that a fair analogy?

Brian McCarthy: I don’t eat lobster, but, yes, I’ve seen people do that. So I would say that’s a very fair analogy, yes.

Amy Chain: How about from a timing perspective? We talked about how these vehicles trade intraday. Is there a better time to think about making a transaction using an ETF? In the morning, closer to the close of the day, or do you need a crystal ball for that?

Brian McCarthy: Well, you need a crystal ball if you want to buy at the low of the day, right? So that would be a great order type. I wish we had it. I like to buy at the low today, but what I would say is I’ll get to, and, Rich, certainly jump in, but the most important thing to pricing an ETF is pricing transparency of the underlying security. So as we talked about earlier, at the end of the day for your conventional mutual fund share classes, the security is closed, your priced security for the fund is priced. For ETFs, securities are trading throughout the day, so the ETF is being priced in real time. So that pricing transparency is really, really important. And so throughout the day, I would say, as an example of pricing transparency, if you were investing in a U.K., an international equity fund, well, in the middle of the day, on New York Stock Exchange time, the U.K. market closes. And, therefore, there’s a little less transparency in the second half of the day. So depending on what investment you’re looking to put your investment in, it may influence what time of the day you want to invest.

Rich Powers: I tell you one thing I would add to that is just being mindful, actually you alluded to this, Amy, at the beginning of the day and the end of the day. So generally speaking what you find is there’s a little less activity, fewer market participants at the beginning of the day or the end of the day. And so as a consequence you might see a little more volatility around the market price of the ETF relative to its underlying value. And so what we generally counsel investors is if you can, maybe avoid that first 15 to 30 minutes of the market time and then maybe at the end of the day that last 15 minutes because there may be anomalous things happening there as market makers and other participants kind of step back and close out their books. Amy Chain: You talked a little bit about transparency and you talked about making sure the price relative to the underlying security— How can people tell? Where should they go to look to see if this ETF that they’re thinking about purchasing is providing price transparency?

Brian McCarthy: You know, Amy, I think there is information available. It’s generally updated every 15 seconds throughout the day. But for the most part, I think the rule of thumb is probably a better guide for investors. And I would just build a little bit on Rich’s point about the open and the close. So at the open, if you think about it, on any given day, on a stable day, generally the ETF would be priced in parity with the underlying securities pretty quickly after the open. But you may have an event such as earlier in June, we had the Brexit event, if you place a transaction on Thursday night and the Brexit vote comes out, what that ETF and the securities may open up at could be very different than where it closed. So if you have some uncertainty for the next day, that’s where you may want to leverage, even if you wanted to trade it there, and control the price that you’re looking to achieve with a limit order. So that’s another opportunity to leverage that.

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