Check your order before you wreck your order

When you get into a car, the first thing you probably do is put on a seatbelt. While no one plans to get into a car accident, wearing a seatbelt can be a godsend if you do. Similarly, while no one sets out to botch an ETF trade, using a limit order adds a layer of control, helping cut the chances of a trade going awry and containing financial damage if it does.

We believe the single most important ETF trading practice is knowing when and how to use a limit order. Just as seatbelts can’t preclude car accidents but can reduce the risk of serious injury, limit orders can’t prevent trading mishaps, but they can help control trading outcomes and costs.

Sometimes, using a market order instead of a limit order means exposing clients to the risk of a trade being executed at a price that’s off from current fair value. Using a limit order instead of a market order—particularly on bigger trades—can help clients and advisors avoid negative consequences.

Below, we’ll get into what can happen when trades are poorly planned, using market orders instead of limit orders. Spoiler alert: Sifting through ETF trades on just one of the 4,851 U.S.-listed ETFs, we found such trades that went awry and wiped out—in a single trading session—years of savings stemming from a low expense ratio!¹

Differences between market orders and limit orders

Market orders prioritize speed of trade execution without regard to price. They may be fine if the trade you’re planning is small. But if not, beware, especially during volatile periods or auction periods, like when the markets open. And the danger probably applies more often to advisors because they’re likely to often trade in size.

Limit orders afford a sometimes-material degree of control over execution price—a safeguard that’s quite relevant when markets are volatile.

Limit orders are designed for buyers to set a price at which they’ll buy and for sellers to set the price at which they’ll sell. Again, think seatbelts for ETF traders.

Bigger trades need more attention

Any trade should begin with basic planning: What is its size, and what’s the right order type? The smaller the trade, the higher the probability that a market order will do the trick.

The bigger the trade, the more likely it is that limit orders are the way to proceed to avoid adverse impacts to client portfolios. As a rule of thumb, we consider trades that are at least 5% of an ETF’s average daily volume (ADV) to be “big” and possibly signal a need to at least use a limit order.

Also, if the trade starts to exceed the number of quoted shares by market makers, the more it makes sense to map out the trade with professionals such as those on the Vanguard Capital Markets Desk.

We created the decision tree below to help investors assess trade sizes and determine which order types might be most appropriate in different circumstances.

Why we favor marketable limit orders

Sometimes, such as in volatile markets when prices rapidly spike or tumble, the execution price of a regular limit order gets eclipsed before all the ETF shares of a planned trade have changed hands.

That’s when a marketable limit order might be the right call.

Marketable limit orders are designed to combine the advantages of both market orders and limit orders. They offer a balance between price control and speed, which can be extremely important for larger trades.²

Setting up limit orders

Once you’ve decided that a limit order is appropriate, it’s crucial to determine exactly where to set “limits” on what you’ll pay if you’re buying, or what you’ll accept if you’re selling.

Setting up marketable limit orders is similar to setting up regular limit orders:

• For buyers, setting limit prices at or near the ask price can help your order execute while still controlling your price.
• For sellers, setting limit prices at or near the bid price can do the same.

Setting up limits in this way helps keep you from paying more or selling for less than the price at which you intend to execute.³

Assessing the wreckage

The chart below shows mostly orderly price action over a multi-month period for a newer ETF that’s still building trading volume. However, the clean trend lines of price action are rudely interrupted by a number of poorly executed trades along the way.

Those aberrant trades share a common characteristic: Each was executed using a market order that led to execution well away from the current market’s fair value only for subsequent trades to immediately converge back to fair value.

The teachable moment here is that, had these trades been set up with limit orders, there’s a high probability that they would have been executed nearer to or at fair value.

1   A marketable limit is designed to get trades executed at the current market price but to do so with a limit to ensure that the execution price doesn’t move away. If a better price is available in the market than an investor’s marketable limit price, the order will still receive the best available price.

2  Investors can make a limit order more marketable by adjusting the price—raising the limit above the offer price for buy orders or lowering it below the bid price for sell orders.

Takeaways

We’ve acknowledged that ETF market orders can be valuable because they prioritize speed. But haste can make waste using market orders, while different types of limit orders can maintain precision and help control trading costs.

Above all, just like you’ve probably made wearing a seatbelt a habit before you start driving, remember that making a habit out of setting up a limit order before submitting a trade can have value, too.

And if you’re still stuck, you don’t have to do this alone. Consulting with professionals, such as those on the Vanguard ETF Capital Markets Desk, makes sense when you’re planning larger and more complicated trades or if you just want to improve your trading practices.

For more information about Vanguard funds and ETFs, visit vanguard.com to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buy-ing and receive less than net asset value, when selling.

All investing is subject to risk, including possible loss of principal.