Exchange Traded Funds (ETFs) make it easy for investors to access professionally managed portfolios. They may provide a solution for achieving an intended investment objective. This article discuses some of the steps in the process of trading ETFs.
The Steps to Buying Exchange Traded Funds
Shares of ETFs are generally as easy to buy and sell as are shares of common stock. And like common stocks, thousands of them exist. That can lead to some confusion. Here are three basic steps investors can take to help clarify the process.
- Open a brokerage account
- Comparison shop
- Place the trade
Open a Brokerage Account
One of the distinguishing features of ETFs is that they cannot be purchased directly from the fund manager. So, the first step in the process to trading ETFs is to have a brokerage account.
Opening a brokerage account can be accomplished relatively easily. It can typically be accomplished over the telephone, online or through a mobile app.
Prior to opening an account, it makes sense to research brokers by their fee structure. While some brokers charge commissions to buy and sell ETFs, many firms offer “commission-free” transactions on some purchases. But there can be other costs.
Some brokers may charge a minimum balance fee. Others might charge a monthly maintenance fee. There can be a fee if a minimum level of activity isn’t maintained. And additional charges may be levied on wire transfers or other housekeeping activities. So, it may be a good idea to understand these other types of added costs.
Comparison Shop
There are many free online screening tools available to help investors sort ETFs by any number of criteria. This ability to screen ETFs helps investors to comparison shop.
One way to search ETFs is by personal investment objective. For example, investors seeking “capital growth” might use that as a screen. Investors looking for “income” could likewise use that term to find ETFs.
From these initial queries, investors could further sort results in finer detail. They might screen by asset class, industry, geography or even an ETF’s portfolio holdings. They could further sort by fund size and/or expense ratio.
Since ETFs trade like common stocks, an investor might also perform research on factors like trading volume, performance or price. After all research questions are answered, it’s time to actually place the trade.
Placing an ETF Trade
Buying and selling ETFs is very much like trading common stocks. Here are some of the similarities:
- They have unique identifiers – a ticker symbol
- Their market price has two components – a bid and an ask
- They can be bought or sold using different types of orders – market or limit
Knowing that an ETF has a specific ticker symbol is important because there is no room for error. Once an ETF order is executed (either bought or sold), there’s no turning back.
Ask Price - the lowest price a seller is willing to accept
Bid Price - the highest price a buyer is willing to pay
Limit Order - an order to buy or sell when the security trades at a set price
Market Order - an order to buy or sell immediately at the current price
Investors are obligated to make good on their trades, even if they are made in error. Buyers must pay for purchased ETFs and sellers must deliver shares of sold ETFs. Mistakes can be expensive to fix. So, it’s important to get the ticker right!
It’s also important to understand just what “market” price means. The market accommodates both buyers and sellers. And their prices are not necessarily the same.
A bid price is the highest amount willing buyers will pay to selling ETF shareholders. Ask price is the lowest price sellers will accept from buyers. Bids are generally lower than ask prices. And together the two represent the “market” for a given ETF.
Market orders are expected to be executed at the best price available at the time the order is received. This mean that a market order to buy will typically be executed at the ask price and a market order to sell will typically be executed at the bid price.
But the market is fluid and these prices change throughout the day. So, ETF buyers and sellers have flexibility when placing orders. In essence, they can name their own price. They do this by setting limits on the price at which they are willing to buy or sell shares.
A limit order to buy will be executed at the specific (limit) price or lower. A limit order to sell will be executed at the limit price or higher.
Market and limit orders are not the only options ETF investors have when placing trades. But they are very straightforward. They are also very common tools for trading an ETF. They may be used as part of a process – that when carefully followed – makes ETFs one solution to achieving specific investment objectives.
Potential Risks of ETFs
Some of the potential risks of ETFs include market risk, asset exposure risk and trading risk.
Market risk means that an ETF can lose value when the market (stock or bond) declines.
Asset exposure risks are related to the specific assets in a given ETF’s portfolio. Some are riskier than others.
Trading risk is related to buying and selling. Trading may create unintended losses and can rack up additional brokerage commissions.
For more helpful information about ETFs, visit our Investor Learning Center.
