In this article, I’ll briefly explain market depth is, market orders, and limit orders. I’ll then explain what marketable limit orders are and why they are important when buying and selling ETFs.
Market depth is the unfilled outstanding orders on the market waiting for a match that meets their price for a trade to go through.
In the above example, we see that:
- there are people waiting to buy at no more than $91.85, $91.80, $91.79, $91.78
- there are people waiting to sell at no less than $91.97, $91.99, $92.00, $92.03
- the difference between the highest unfilled buy order and the lowest unfilled sell order is called the spread.
If you put in a market order to buy, it will be matched with whatever the lowest offer (seller) shown at the top right of the image is, and the order will go through at that price.
If you put in a market order to sell, it will be matched with whatever the highest bid (buyer) show at the top left of the image is, and the order will go through at that price.
A market order will always go through — provided it is during exchange opening hours and there are buyers and sellers, which for commonly traded shares there will be.
A limit order allows you to make sure you don’t pay beyond an amount of your choosing.
If you put in a buy order that is above the lowest offer (seller), your order will be matched and a trade will occur at the price of the existing order. So if you put in a buy order for $100, it will still be traded at $91.97 — unless at the exact moment they cancel their order, and then you will be matched with the next order for $91.99.
Similarly, if you put in a sell order that is below the highest bid (buyer), your order will be matched and a trade will occur at the price of the existing order. So if you put in a sell order for $80, it will still be traded at $91.85 — unless at the exact moment they cancel their order, and then you will be matched with the next order for $91.80.
Unlike market orders, if your limit is not met, it will become an unfilled order in the market depth until or your order is filled, or your cancel it, or it expires.
ETFs vs Managed funds
ETFs and managed funds are structures/investment vehicles that hold a basket of underlying shares and offer them to be purchased as a single unit.
Where they differ is that managed funds are purchased through the fund provider directly. Vanguard’s managed funds are an example of this. In this case, when you want to buy, you put in an order through your Vanguard account, and all the buying and selling for the managed funds is done after market close, so the price you buy and sell at is exactly their net asset value (NAV).
On the other hand, with an ETF, as the name ‘Exchange-Traded Fund’ implies, it is traded on the exchange in real time just like direct shares. This makes it more convenient as you don’t need to have an account with each fund provider. Instead, you can trade with any broker, any time you like (during exchange opening hours).
However, a problem would arise if there were not enough people buying or selling close to the net asset value (NAV) of the underlying shares the ETF holds. To overcome this, a market participant called a market maker is appointed by the company offering the ETF to provide liquidity (liquidity refers to the ability to be converted into cash without affecting its market price).
When there is no one in the market selling parcels of an ETF near the NAV, a market maker will effectively buy and package up the underlying individual securities, convert them into ETF parcels and offer them at NAV (plus a small spread to pay the market maker for their job). This provides liquidity to the ETF market. I.e., it ensures there are always ETF shares available to buy that are in line with the NAV.
It works the other way too. When there is no one buying parcels of ETFs near the NAV, a market maker will effectively buy ETF shares at NAV (minus a small spread) and convert them to the underlying individual securities and sell them off. Again, this provides liquidity to the market, ensuring you can always sell your ETF shares at NAV.
They are called market makers because when there is no market (i.e. nobody buying or nobody selling), they make (create) a market for people to buy and sell.
For the most part, ETFs are accurately priced because of market makers. However, there are certain times where it’s more likely to drift from NAV, and I go into this in the following section and how to avoid the problems associated with it.
Always use ‘marketable limit orders’ with ETFs
Always use limit orders. It’s just a matter of eliminating tail risk (those couple of times market makers have suddenly disappeared and spreads have blown out).
When you make a purchase, ignore the last price because, for lower liquidity ETFs, the last price could have been hours of trading earlier or even the day before and no longer reflect the price that people are willing to buy and sell at.
Just place your order a few cents below the bid if selling or a few cents above the ask if buying. It will act just like a market order, but you’ll never have any big surprises.
Being tricky and trying to price it lower when buying and higher when selling doesn’t actually help.
Vanguard suggests this for ETFs and calls it placing marketable limit orders.
** Note: some brokers don’t have real-time prices (some charge a fee for that, some just don’t have it). If that is the case with your broker, you can open a Commsec account, which is free just to have and not to trade with, but you can see real-time prices to know how much to use for your marketable limit orders.
Times to avoid trading ETFs
There are a couple of times when market makers are more likely to not be doing their job properly.
You should avoid
- trading in the first or last 15 minutes of the trading day;
- placing an order during off-market hours expecting it to be filled at the market open.