ETF shares are sold and bought through a stock exchange. When you are buying or sell shares of an ETF you are effectively transacting with another investor and not with the Fund Provider (e.g. iShares, Vanguard) through a stock exchange.
A stock exchange is a marketplace where multiple investors indicate their desire to buy/sell securities at a certain price. These instructions to buy/sell securities are called orders. It is the exchange’s job to coordinate all these orders so that each investor gets the best available price that fulfills their criteria.
There are many types of orders an investor can use to trade ETFs.
Some people use market orders to buy/sell ETFs. In a market order you give an instruction to buy/sell ETF shares immediately at the current market price. In a market order you don’t specify the price you want to trade at, you just indicate how many shares you want to exchange. These orders are simple to understand and fast to execute. A market order is a bit like saying “I want to buy 10 shares of the iShares MSCI World ETF, at the best available price”.
You should not use market orders because:
- you don’t control the price – the (mid) price you see on your broker is not necessarily the price at which your order will be filled. The order may be executed at a higher or lower price than what you intended. These issues are less likely whenever there is low volatility in the market and/or the ETF has a high trading volume but they are possible.
- your broker may require higher balances in your account than what you need – Imagine you want to buy 10 shares at market prices, you see a (mid) price of EUR 100 and you have EUR 1000 in your account. Even though it looks like you have enough cash balance to fulfill a market order for 10 shares, your broker can ask you for a higher balance (e.g. EUR 1100), because it does not know at which specific price your market order will be filled.
Limit orders don’t have these shortcomings. They allow you to control the price and as a consequence don’t require you to have a higher balance in your account than needed.
In a limit order you give an instruction to buy/sell a certain number of ETF shares at a certain price. The limit order will only be fulfilled if (and when) there is somebody else interested in transacting with you at that price. A limit order is a bit like saying “I want to buy 10 shares of the iShares MSCI World ETF and I am willing to pay up to 80 EUR for each share” or alternatively “I want to sell 10 shares of the iShares MSCI World ETF and the lowest I will go is 80 EUR per share”.
Limit orders are a bit more complex because you have to determine the price at which you want to exchange the ETF based on the price expectations of other participants. That is, there is no point in creating a limit order to buy the iShares MSCI World ETF for 1 EUR a share if other market participants are only willing to sell each share for 80 EUR – your order won’t be fulfilled.
The bid and ask is how you understand the prices at which the market participants are willing to exchange the ETF. The bid is the highest price someone is willing to buy an ETF share for. The ask is the lowest price someone is willing to sell an ETF share for. Alternatively you can also look at the order book and see the full list of existing buy/sell orders.
Depending on the price you choose for your limit order the likelihood and the time it takes for it to be fulfilled changes. If you want to fulfill your limit orders quickly, you may create orders which have prices equal to or slightly better than the bid-ask. By slightly better I mean a buy limit order with a price a penny higher than the bid or a sell limit order with a price a penny lower than the ask.