What Is The Effect Of Liquidity On An ETF?

Some of the more popular, actively traded ETFs such as the SPY or QQQ have a tremendous amount of liquidity, meaning that many shares are continually changing hands during the regular trading session (and often in pre-market & after-hours trading as well). As such, the spreads on actively traded ETFs are very tight, typically just a one cent difference between the bid (selling) and ask (buying) price. However, many ETFs & ETNs are thinly traded and as such, may experience considerable spreads at times, thereby offering less than favorable entry and exit prices, especially when using market orders.

When at all possible, it is preferable to use the most liquid (actively traded) ETF for the specific index, sector, commodity, etc.. that you wish to trade. However, when a thinly traded ETF is the only option available, the use of limit orders may be a better option than market orders although there are pros and cons to each. For example, if a thinly traded ETF that you were looking to buy currently had a bid price of 10.40 and an asking price of 10.50, a market order to buy would most likely fill at or near the 10.50 price, possibly higher, depending on the number of shares you are purchasing. Let's say you placed an order to buy 500 shares but there were only 200 shares being offered at the 10.50 ask price, then your first 200 shares should fill at 10.50 while the remaining 300 shares could fill at an even higher price due to slippage on the trade. With a spread of 10 cents, even if all of your shares filled at 10.50, you have immediately "lost" (on paper) about 1% on the trade just due to spreads alone as you would only get 10.40, possibly less, if you immediately sold those shares.

Therefore, the use of a limit order may be beneficial over a market order in this case. For example, one could place a limit order to buy the 500 shares at a price of 10.45, splitting the different between the bid & the ask price. The benefit to doing so would be that your order would only be filled at a price of 10.45 or better. However, there are two potential disadvantages to using a limit order in such a scenario: First, your order may or may not be filled. If you felt strong about entering this position, you risk that the price continues to move higher without your order filling and you must either decide to be comfortable not owning the position if it continues to move higher or to pull your limit order and "chase" the stock higher via another limit order or a market order.

The other potential pitfall of a limit order on a thinly traded stock or ETF would be a partial fill. In the example above, maybe your order to buy 500 shares at 10.45 is filled but only for 100 shares or less. If the order was a day order (good until the close of that trading session) and the remaining shares are not filled, then you will end up with a much smaller position that you originally wanted. Yes, a GTC order might fill the remaining shares in the coming days or weeks but with separate commission costs as most brokers will only aggregate fills, in calculating the total commission, on separate lots for a limit order if the fills on all lots occurred during the same trading session.

One final consideration regarding the liquidity of ETFs is that at times, ETFs that normally have large spreads due to low trading volumes can experience very tight spreads during periods of high trading volumes, such as a breakout in a sector or some news driven event that suddenly draws a lot of traders in. You may purchase that ETF with a market order noticing that the spreads are tight, only to find it hard to exit the position at a favorable price only a few days or weeks later after the volume surge has dried up. Therefore, it is best to know the history and average trading volume of the ETFs/ETNs that you plan to trade and account for any slippage or other liquidity issues that you might run into when formulating your trading plan.

Mar 24, 2016 5:57pm|Comments Off on What Is The Effect Of Liquidity On An ETF?