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Understanding ETF Order Types

Understanding ETF Order Types
April 26
01:40 2012

The mechanics of trading ETFs differ little from what is involved in trading stocks. Here we’ll briefly describe the major order types normally used in ETF trading and touch on some advantages and disadvantages of each.

The basic, garden-variety buy or sell order is the market order. This is a simple instruction to buy or sell the ETF in question at the best available price, as soon as possible. Ideally—assuming a highly liquid ETF—a market order is fulfilled immediately, though in this case “immediately” doesn’t necessarily mean “instantly.”

In a typical situation in which you place a market order from your computer, that instruction has to get to your broker and from there get routed into the marketplace. Institutional and professional traders have direct access to the electronic trading networks (ETNs), so their orders will typically get filled more quickly than yours will.

Most of the time this makes little—a matter of a couple of pennies or so—or no difference in the trade price, but with a fast-moving ETF, you may find yourself surprised by the settlement price—what you actually end up paying. Market orders normally expire at the end of the trading session if for some reason they have not been filled.

Sometimes you may be watching a particular ETF that you’re convinced is heading up or down. If you want confirmation of the direction of the move, for example, you might make a limit order. Limit orders are fulfilled only when the price reaches a certain point—the limit—or better. Other than that, once the limit is reached they act as a market order.

Limit orders normally specify a maximum price to be paid for a purchase or the minimum price to be received for a sale, though they can also be time-constrained. Of course, if the limit price never becomes available, the order won’t be executed. Limit orders are very handy for low-volume or high-volatility ETFs, since they save you the trouble of monitoring for your desired price.

Similar to the limit order is the stop order, sometimes referred to as a stop-loss order. A stop order establishes a boundary—the stop price—and once the ETF crosses that boundary, a market order is placed. It is used for similar purposes as the limit order, in that the trade will not take place until a certain minimum or maximum price has been achieved. Be aware that with fast-moving ETFs, the price can conceivably gap beyond your stop in either direction. Such orders are often used as a security mechanism when placed at critical support levels to exit a position in case the ETF’s price heads south, hence the term “stop-loss.”

Combining the features of the limit order and the stop order produces the stop limit order. The stop limit order specifies at what price or better an ETF should be bought or sold, but only once the stop price has been crossed. As with conventional limit orders, there is no guarantee that a stop limit order will actually be fulfilled.

Finally, it is possible to place a short sale. Shorting an ETF actually involves selling an ETF that you don’t own, on the assumption that the price will decline. You will then be able to buy the ETF at a price lower than that at which you sold it, making a profit on the transaction. However, if the ETF actually rises in price, you will be forced to buy it at that higher price and lose money on the deal. Also, you will incur margin interest during the period that you borrow the ETF.

Limit, stop, and stop limit orders can be valuable tools for managing your trades, especially when it comes to protecting you against unexpected price movements. Plan your trades to rely on the minimum number of such orders, however, because all of them cost more than market orders and will increase your trading expenses.

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