Tips for Trading ETFs

NEW YORK (TheStreet) -- The ETF universe is expanding, and new products are launching on a weekly basis. While most large, liquid ETFs provide transparent, low-cost exposure to sectors and themes, the performance of some funds has been disappointing and even misleading for some investors.

The advent of electronic trading has made it easier for individual investors to trade ETFs, but successful order execution requires more than just an idea and a computer screen.

Whether you are looking to buy a large market index like the SPDR S&P 500 ETF(SPY Quote), a commodities fund like SPDR Gold Shares(GLD Quote) or an international fund like Vanguard Emerging Markets(VWO Quote), the following tips will help you select "ETFs that work" and trade them successfully.

Pick ETFs That Work

An "ETF that works" is one that successfully tracks its underlying index. Every ETF has two values: an underlying net asset value (NAV) and a market price during the trading day.

ETFs are designed as transparent trading vehicles, whose share creation and redemption processes keep the funds' market price in line with the funds' NAV.

During the trading day, there will be very little difference between their NAV and market price in the most successful ETFs. The bid/ask spread will be tight, and investors can trade in and out of the fund without having to buy at a premium or sell at a discount.

Liquid ETFs, whose market price closely tracks their NAV, provide the tracking and transparency that investors should expect when dealing with these products.

In order to test the liquidity of an ETF before purchase, investors should look at the prospective fund's average trading volume. Some very liquid ETFs like PowerShares QQQ(QQQQ Quote) will have three-month average trading volumes in the millions.

ETFs with average daily trading volumes greater than 50,000 shares are generally liquid. Investors looking to buy a fund with lower trading volume should make sure that their order would not represent more than 10% of the trading volume on an average trading day.

Knowing When to Trade

Certain times of the day are better than others when buying and selling an ETF. Investors should look to buy and sell ETFs when they are most likely to closely track their NAV. This is generally during times of the day when market participants can actively arbitrage and provide tight markets in ETF products.

During the opening of the market at 9:30 a.m. EST and the last 10 minutes of trading (3:50 p.m. to 4 p.m.) there are often order imbalances. During these times, supply and demand is more apt to determine market price than the underlying value of the ETF. These market forces can cause an ETF to trade at a steep premium or discount to underlying value.

While gaps between NAV and market price do not always occur at the openings and closings of the market, regular investors are better off waiting until after the open to execute an order. Often, an ETF is more apt to trade close to its underlying value at 9:45 a.m. rather than 9:30 a.m.

Order Types

There are several order types that investors commonly use when executing ETF trades. A market order, which is time sensitive but not price sensitive, executes immediately at the next bid or offer. If an ETF is liquid with a tight bid/ask spread near NAV, a market order should be sufficient to get an appropriate price.

Investors who insist on trading less liquid products, with larger bid/ask spreads, may have better luck trading with limit orders. Rather than entering a market order, which sweeps the book without regard to price, investors in illiquid ETFs may be better entering a limit order at last sale.

While this method does not guarantee execution, limit orders are price sensitive. By entering a limit order, you can be assured that you will not get five different prices during execution, with each price further away from NAV.

The variety and complexity of ETF products requires basic knowledge of trading principles in order to get successful execution. These three tips are a good place to start.

-- Written by Don Dion in Williamstown, Mass.