All financial products that are traded on the exchanges do have spreads. The same goes for an ETF of course. Here I will explain what exactly is meant by a spread and how you can prevent large spreads.
How does a spread occur with an ETF?
On markets buyers and sellers are constantly active. A buyer wants to obtain a price as low as possible and a seller wants the opposite, a price as high as possible. Brokers hold books where all bid and ask prices are mentioned.
Most brokers offer these bid and ask prices online. If one agrees on the price a deal is being made. Buyers want to buy an ETF for a so-called bid price and sellers want to sell for the so-called ask price.
When giving a market order you want to buy or sell a particular ETF immediately. When you are buying through a market order you will get the ask price of a selling party that is thus higher than the price of the highest bid of other buyers in the book.
When you are selling through a market order you will sell for a price that corresponds with the highest bid price which is lower than the ask price.
The difference between a bid price and ask price is the spread. To put in other words: If you are buying an ETF through a market order and you are selling it within milliseconds you will lose money and that loss is the spread.
How I avoid spread loss in ETF’s
First and foremost, I will never give a market order when buying or selling an ETF. I will always use a limit order. With a limit order you will stipulate the maximum price you are willing to buy an ETF or the minimum price you want to sell your ETF.
Of course it will be wise not to put a price on your limit order that is too far away of the current bid and ask prices otherwise your chance of making a deal would be very slim. I will always make a limit order with a price between the current bid and ask prices.
With a slight change of prices I will then get a slightly better deal. Another advantage of a limit order is that with sudden price changes you will not get a very unfortunate price.
Why the spread may be large with an ETF?
If there is very little trading going on spreads may become larger. The more trading, the smaller the spreads. If a particular ETF is aimed at a niche market spreads will be automatically larger.
But also very popular ETF’s may see some large spreads on slow trading days. Even intraday changes in spreads may happen, sometimes during a trading day spreads will widen, especially over lunch-time.
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