Exchange-Traded Fund Best Practices: Bid-Ask Spreads and Types of Orders

A major rule to follow is checking the bid-ask spread. You will want this to be as small as possible, as the smaller the spread, the more likely you are to trade at or near the net asset value. In addition, a thin spread should minimize your cost upon sale. These spreads are generally measured in pennies, so market makers derive their profits through volume. Higher-volume funds will usually be the beneficiaries of a tight spread whereas those funds that sparsely trade will not.

Use limit orders

Limit orders are the most effective here. Do not use market orders or stop orders. A limit order specifies a certain price above which you won't buy or below which you won't sell. While a limit order prevents one from paying more than or selling for less than an amount deemed appropriate, it won't prevent you from getting a better price on either side of the trade. However, limit orders do not guarantee trade execution if the limit price is not reached.

A word on stop-loss orders

For long-term investors, stop-loss orders should also be avoided. A stop-loss order becomes a market order once the limit is passed. Thus, one exposes oneself to the same dangers of the market order. A stop-limit order becomes a limit order once the limit is triggered. The problem here is that in a volatile market, the limit could have could have been passed on the way down, but stands to dump the position on the way up, limiting the upside of the run. Again, stick to limit orders and be patient.