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By Michael Rawson, CFA | 11-06-2012 03:00 PM

Best Practices for ETF Trading

Street One Financial President Scott Freeze discusses the utility of limit orders, indicative values, patience, and more for optimizing ETF trades.

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Mike Rawson: Hi, I'm Mike Rawson with Morningstar.

We are here today talking about ETF trading, and joining me is Scott Freeze. Scott is the President of Street One Financial.

Scott, thanks for joining me.

Scott Freeze: Thanks for having me.

Rawson: When it comes to ETFs versus mutual funds, we all know that the difference, at least the primary difference, is that ETFs are traded on an exchange. Now, that can be an advantage, but it could also quickly turn into disadvantage if you're not careful with what you're doing.

So, let's talk a little bit about ETF trading. Let's start off with limit orders.

Scott, what is a limit order, and why might I want to use a limit order when I'm trading an ETF?

Freeze: A limit order is when you put out a specific price that you want to buy or sell the ETF at. So, instead of just saying "market," where you could just get whatever the next offer is or whatever that price will get filled at, with a limit order, you're specifying, I will pay no more than this or I will sell it at no less than this price.

Rawson: Some people say that you should always use limit orders with ETFs. But let's say I am an average investor, and I'm just going to put $10,000 into something that's very liquid--maybe a core portfolio type of ETF. Do I need to use a limit order on something that's as liquid as maybe the SPDR S&P 500 ETF, SPY?

Freeze: Probably not. Something like the SPY, at $10,000 worth, it's going to be millions of shares up at each price point, and it's only a penny wide. So, you can sell it at $0.63, you can buy it at $0.64. If you hit market for $10,000 worth, you're going to get filled on the bid or on the offer, depending on what side of the market you're on.

Limit orders really don't come into play until you're talking about more esoteric, thinly traded ETFs. Maybe if it has a wider spread, say $0.05 or more. If it's something that trades 400 shares a day, 2,000 shares a day, then you might want to start looking at limit orders, just so that you don't have any adverse price impact, because I'm sure a number of your viewers have seen where they hit sell, it's a market order, the ETF is trading in a flat line, they get filled down here, and it comes right back up, and they become that T in the chart. It's just because the market order wasn't appropriate there; they could have been filled right on the flat line if they would have just had a limit order out there.

Rawson: OK. So, you mentioned a big price deviation where the price drops and maybe comes right back. When we trade in an ETF, do we need to be aware of the net asset value of the underlying fund? Is that something that you look at?

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