The battle between hedge funds and retail investors over shares of GameStop in early 2021 ignited one of the most drastic rallies and declines ever seen in a single stock. A hedge fund-driven short squeeze and the momentum of thousands of Reddit investors piling into the stock added fuel to the fire and even triggered trading halts. Since ETFs trade on an exchange, gyrations in the stock market and market-wide volatility can impact ETF trading and execution, but ETFs once again proved to be resilient. To help navigate the market frenzy, it’s always beneficial to revisit three trading best practices when it comes to ETFs.
Use limit orders when trading ETFs
A market order may be effective when placing small trades in highly liquid ETFs, but there is a risk that it could be executed at an undesirable price, especially in highly volatile markets as witnessed in early 2021. A limit order lets you set the price at which you are willing buy or sell an ETF, helping you avoid paying more or selling at less than a desired price. However, with limit orders, there is a risk that your trade will not be executable at the specified price, so the closer your price is to the bid or ask, the greater the probability that your sell or buy will be executed.
||Buy/Sell at best available price
||Buy/Sell at a specified price or better
Be mindful of market volatility
The market volatility surrounding the GameStop saga is a reminder to be mindful when trading during periods of heightened market volatility. When the market is erratic and underlying security prices are unpredictable, it can lead to a widening of an ETF’s bid-ask spread, causing the ETF to trade at a larger premium or discount than normal. In fast-paced environments, it may be more prudent to wait for volatility to subside before placing a trade.
Watch the clock with ETF trades
In general, it is recommended to avoid trading within the first and last 15 minutes of the trading day. This is because not all of an ETF’s underlying securities may have started trading within the first few minutes of the session, in which case the market maker cannot accurately price the ETF.
Also, it’s generally preferable to trade international-focused ETFs at times that coincide with the trading hours of the underlying securities’ local markets. For example, prices of ETFs trading in Europe tend to be more accurately priced and trade with narrower bid-ask spreads when their respective markets are open and overlap with European trading hours.
In some cases, it may not be possible to trade international ETFs when the underlying market is open (i.e. some Asian and European markets). In this case, market makers may use alternative methods to price an ETF when the underlying market is closed, such as futures contracts, to keep spreads from widening out significantly.