Best Practices in ETF Trading: Know Your Limits

Posted on 07/22/2014

A basic understanding of ETFs is something many of you have in your arsenal, but we are still frequently asked about industry "best practices" on a daily basis and often surprised at which observations seem to be most appreciated by those who reach out to us. Some of the best universal advice we can offer regarding ETFs is also some of the simplest, and strangely we've not put all of it in print to date. For what it's worth, what we will be covering over the next several days is simply a handful of "ETF 101" considerations, meant to be neither impressive or comprehensive, but yet imperative for the professional to grasp and implement as second nature before any "highlight material" can be filmed in the markets.

Over the last couple of years there have been various debates regarding the premise of how some ETFs were structured and to be sure there are still the painful memories of the "flash crash" to help us all remember how stocks such as Proctor & Gamble and various ETFs can behave when markets move toward the margins of volatility. While the flash crash may have begun with Proctor and Gamble [PG], about 2/3rds of the eventual scratched trades from that session were ETF transactions, and this prompted a great deal of evaluation from regulatory bodies and exchanges combined. A number of steps were taken to reduce the likelihood of something similar happening against, including new limit order standards on the NYSE Arca electronic trading platform, which still has the greatest market share in ETF trading. Logistic details are available in the article, "Arca Sets New Limit Order Standards," but the gist is that the NYSE instituted "price checks" aimed to block limit orders that are priced too far from the national best bid (NBB) or national best offer (NBO). Stop loss points that were stationed well away from the market on May 6th, 2010 (Flash Crash) turned into market orders quickly as the Dow plummeted by an eventual 1,000 points. In this fashion, lower prices created more supply, as limits became reality.

That said, the advice passed on to us from the trading desks we are in constant contact with is to use limit orders wherever possible to enter and exit ETF exposure. More specifically, a common approach is to use the Indicative Net Asset Value (iNAV), or Intraday Indicative Value (IIV), as a guidepost for placing limit orders to buy or sell an ETF as opposed to market orders.

 

What is the Indicative Net Asset Value (iNAV), or Intraday Indicative Value (IIV), of an ETF?

The "iNAV," "IV" or "IIV" quote for an ETF is simply the intraday net asset value (NAV) of the ETF. ETF providers are required to contract 3rd party institutions to calculate and disseminate an "iNAV" quote stream that is updated throughout the day, generally at 15-second intervals. This iNAV quote gives an updated measure of the value of the actual basket of securities that make up the ETF. An ETF will have published end-of-day NAV information as well, but the iNAV quote offers a more real-time representation of the basket's value throughout the day. Generally the iNAV ticker symbol for an ETF that trades under XYZ would simply be XYZ.IV.

 

 

With "iNAV" quotes being regularly re-freshed during the day we generally find that advisors are pleased with a practice of buying with limit orders a penny or two above iNAV, or selling on a limit order a penny or two below the "IV" quote for most securities. In the example above, we've shown trading data for the Russell Top 50 ETF [XLG] as an illustration of an important point. One reason some are inclined to steer clear of a fund like XLG is that we are preconditioned to view a Bid-Ask spread of 5-10 cents with a great deal of skepticism, and XLG commonly "shows" a 10 cent spread. Certainly if you were to grab a quote of IBM, only to see such a wide spread, you would presume you'd either lost track of time or IBM is in dangerous territory. While this is probably true in that scenario, it is hardly the case for ETFs. Notice that the highs and lows for each "10 minute" trading window for a fund such as XLG tend to encapsulate nicely the trades for XLG occurring in that window. In other words, while the spread for XLG can be observed in the 5-10 cent range quite frequently, trades can generally get "done" closer to NAV throughout the day. The trades in the graphic above show this to be the case. As the fund traded modest volume over this particular week, those trades were executed around the value of the basket ... which is what "iNav", "IV" or "IIV" represents. Someone looking to add exposure to the Russell Top 50 Fund [XLG], but initially seeing a spread that is perhaps uninviting, might use the iNAV quote to gauge a level at which a "fair" limit order could be placed.

What about stops?
As a rule, stop loss orders that become market orders upon a price being hit are not recommended. There are of course many instances where a "hard stop" may well have served to be useful, but as a rule there is a stronger case to avoid such orders with ETFs, as they will often experience the detriment of the full spread in an ETF market, where limit orders will often provide better execution when used properly.


This article has been tagged in:
Symbol Performance
KWEB 53.210%
EMQQ 53.152%
ARKK 51.072%
CXSE 49.741%
ARKW 49.408%
PGJ.TR 47.403%
SCIF 47.167%
PGJ 46.625%
PLND 45.563%
CQQQ 44.514%
SCIN 44.208%
Sector Symbol Performance
Technology FDN 49.408%
Real Estate FRI 36.777%
Healthcare BBH 36.493%
Basic Materials GDX 35.403%
Financial BSV 29.430%
Energy DBE 28.546%
Consumer Cyclical FXD 24.818%
Utilities FIW 17.469%
Industrial EXI 17.037%
Consumer Noncyclical FXG 13.427%
Telecommunications IXP 12.707%
Financial Services FREL 4.776%

AllETF Social