Investing Basics: How does ETF trading work?

Before you buy your first ETF, it’s a good idea to learn the trading essentials. Find out how ETF pricing works, the impact of the spread and how to protect yourself with limit orders – by Dominique Riedl.

One of the big advantages ETFs have over traditional mutual funds is that ETFs are traded throughout the day when stock markets are open. As you’d expect, you can buy or sell at the latest price quoted on the London Stock Exchange, and the price continually changes in line with the forces of supply and demand. So far, so normal.
 

The ETF trading essentials

 
Traditional funds don’t work that way. Strangely, you don’t know what price you’ll get when you place a fund order. That’s because you trade at the fund’s Net Asset Value (NAV) price – and that price is only calculated once a day, usually at 12 pm. The NAV is the best estimate of the underlying value of the fund’s assets but, if you place your order at 2 pm, then it will be executed at tomorrow’s 12 pm valuation price. This is known as forward-pricing.

ETFs also publish their NAV once a day, but you’ll generally trade at or close to the market price quoted by your broker.
 

How does an ETF price come about?

 
The price of an ETF is constantly being updated. It is the result of deals being struck by market participants on the stock exchange as they respond to fluctuations in supply and demand. That trade flow is why you’ll be quoted a fresh price every 15 seconds or so by your broker when you trade an ETF.

Prices are updated as buyers are matched to sellers on the London Stock Exchange via a system called SETS (Stock Exchange Electronic Trading Services).

Your broker places your order on SETS, and the system hooks you up with other investors who are trading at the same time. Like a fast-moving financial Tinder, SETS is all about market efficiency. For example, a large purchase can hoover up the shares of multiple sellers, while a large sale may be split between many buyers.

Then it’s the job of market makers to step in when buyers and sellers can’t be perfectly matched. Market makers tend to be large global banks or specialised liquidity providers that facilitate trades from their own inventory of ETF shares. When sellers outnumber buyers, for instance, a market maker guarantees liquidity by purchasing the shares flooding onto the market. They perform the same role in reverse: selling ETF shares from their inventory to complete orders when demand outstrips supply.

Competition between market makers enables ETFs to be offered at the best possible price. This underlying mechanism ensures the ETF price closely matches the value of its index. The market makers are able to trade ETF shares and/or their constituent securities to ensure the two don’t diverge markedly. High volumes on the buy or sell-side can lead to wider spreads during periods of market uncertainty. But market makers swiftly respond to imbalances and tighten the spreads. This is important as spreads are a cost that investors pay. (See the ‘What is the spread’ section below).

This is a big difference between trading shares and trading ETFs. There is a limited number of shares – and the price is determined by order book supply and demand. Whereas, the number of ETF shares is variable. They can be created or cancelled to match supply and demand. This market mechanism minimises spreads and ensures that an ETF tracks the Net Asset Value of its constituent securities.

This dynamic plays out behind the scenes, though. It doesn’t change how you practically trade ETFs on the exchange.

Today, price determination for ETFs is largely automated. Many prices are calculated by computers without human assistance. This facilitates fierce competition between multiple market makers on electronic exchanges such as the LSE. Ultimately, only the best price position wins investors’ orders. For this reason, it’s often more cost-efficient to trade ETFs that track highly liquid markets such as the FTSE 100, MSCI World or S&P 500 than to buy the individual securities from the index. That’s a win for retail investors.
 

justETF tip: Additional sources of liquidity are available through the ETF creation and redemption process and over-the-counter trading (OTC). OTC transactions are large orders that take place between giant institutional players away from the stock exchange. That matters to a retail investor because OTC trading may well mean that ETFs are more liquid than they appear if you purely use on-exchange trading volumes as your guide.

What is the spread?

 
Every ETF has a buy price (bid) and a selling price (offer). The buy (or bid) price is what a buyer must pay to own an ETF share. The sell (or offer) price is what a seller is paid for an ETF share.

The bid price will always be marginally higher than the offer price, and the difference between the two is called the bid-offer spread. The spread is collected by the market maker as their commission for matching the buyer with the seller.

The bid-offer spread is a dealing cost born by ETF investors every time they trade, and it’s constantly changing.

You can work out the size of the spread by comparing the bid and offer prices of your ETF and applying the following formula:
 

 
The size of the spread depends on the market’s efficiency. Spreads tighten when it’s easy for market makers to connect buyers with sellers. ETFs with high daily trading volumes and liquid underlying assets usually have the narrowest spreads. For example, the spread on FTSE 100 or S&P 500 ETFs usually amounts to pennies.

Competition between multiple market makers also tightens the spreads of popular ETFs. Look at the number of market makers listed on an ETF’s product page. The more, the better, as they’re forced to offer keener, spreads to maintain their market share of orders.

Conversely, volatile markets tend to widen spreads. Under these conditions, fast-changing prices make it hard to gauge an ETF’s NAV, and so market makers expand the spread to give themselves more room for error.

You can estimate the spread yourself before placing an order. Just check the buy and sell price displayed on your broker’s order screen.

Irrespective of this, the spread can widen if there is turbulence in the financial markets.

Know your orders

 
You’re not guaranteed to trade at the price quoted by your broker. The price can be taken by someone else or withdrawn before your order is fulfilled. Sometimes part of your order is filled at the quoted price, but the rest of your order is executed at the next best available price. Here are the most common trading orders you can use to manage the prices you receive:
 

At Best / Market order

 
You buy or sell immediately at the best available price. A market order enables the speed of the execution, but the price isn’t guaranteed. Your order could be filled at a better or worse price than your broker’s quote. However, you can usually expect execution close to the last quoted price in a reasonably liquid market.
 

Limit order

 
Limit orders enable you to set your price. A Buy Limit order means you’ll buy at your specified price or lower. A Sell Limit order means you’ll unload at your specified price or higher. Limit orders are usually filled at your chosen price but of course, your order will expire if the market doesn’t reach your set level. Limit orders are the best way to protect yourself from trading at an unfavourable price in volatile or illiquid markets.
 

justETF tip: Place your limit order to match the best available offer price.

Stop-loss order

 
This order is designed to limit your losses. You set a stop price and your ETF is automatically sold if its bid price falls through that level. The price you get is the best available current price, although that can be a double-edged sword. If the market is tumbling fast, then you may sell well below your stop price by the time your order is fulfilled. Moreover, your ETF can rebound back above your stop price very quickly (even the same day) as happened to some investors during the Flash Crash of 2010. Stop-losses can protect profits but use with caution.