Rules for trading ETFs in volatile times

By , on August 16, 2016

(ShutterStock image)
(ShutterStock image)

Historically, the August through October period has been one of the most volatile periods for investors. This year looks to be no different, with many factors likely to weigh on investors, including uncertainty over the recent Brexit vote, uncertainty out of China, and worries over the timing of the U.S. Federal Reserve’s next interest rate hike being just a few.

In more volatile times, some investors may be looking to make some changes to their portfolios. However, thanks to the volatile markets, they may also find that they don’t get the prices they want for their ETF trades.

To trade ETFs successfully, there are a few rules to pay attention to in order to get the trade execution you want.

Vanguard Canada has published a great piece on its “ETF Education Centre” site that outlines some of their suggestions. (The information is also available from Vanguard in downloadable PDF format.). Here’s a summary of Vanguard’s suggested trading rules:

Use limit orders. A limit lets you set your buy or sell price, while a market order will be filled at the next available price. The key problem with the market order is that the price at which your order is filled may be considerably higher or lower than it was when you placed the order. A limit order will be executed only at your pre-set price or better. However, keep in mind that a limit order may not be filled at all if there’s no matching bid or offer. But this may often be desirable because it prevents you from executing your trade at a price you don’t want.

Watch bid/ask spreads. The difference (spread) between the buy and sell price can vary, especially when markets become volatile and unsettled. In general, look for wider spreads when using a limit order.

Liquidity of underlying holdings. Note that trading volume is not “liquidity,” and often, volume and liquidity may be unrelated. In fact, it’s the liquidity of the individual securities comprising the ETF that determines overall liquidity for the fund. Large-capitalization U.S. stocks tend to be highly liquid, for instance, while small-capitalization Canadian stocks (especially junior mines and the like) tend to be quite illiquid. Less liquidity among underlying investments is typically reflected in wider the bid/ask spreads.

Avoid trading at market open and close. The stocks comprising the basket of ETF holdings may not all trade at the opening of the market each day. And this could mean lower liquidity for the fund, which in turn leads to wider bid/ask spreads and pricing that may be higher or lower than your target. Bear in mind that few firms are willing to make a market for ETFs at the close of trading. This will also tend to make the ETF less liquid, with undesirable pricing at the end of the day.

Trade when overlapping markets are open. Trading on underlying securities held by an ETF may be closed in the case of non-North American equities and sometimes with bonds. When the market for the underlying securities is closed (say in London or Paris) while domestic markets are still open, market makers lack real-time information for pricing, often resulting in wider spreads. As a rule, trade European and some Asian ETFs in the morning, while market activity overlaps. Also, keep in mind that Canadian and U.S. markets may be open or closed where respective holidays don’t overlap (Thanksgiving Day, for example). Trading hours for bonds tend to coincide with equity markets, except for a very few days, such as Remembrance Day in Canada.

If you watch these factors, you’re less likely to get burned by the market volatility.

Courtesy Fundata Canada Inc. © 2016. Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson & Associates Inc. This article is not intended as personalized advice. Investments mentioned are not guaranteed and carry risk of loss.