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Trading ETFs, Liquidity, Depth Are Different

In an electronic trading age where bid/ask spreads seem tighter than ever, how can a relatively small buy order in a seemingly liquid ETF produce such a noticeable premium? There's more to liquidity than average daily trading volume and tight bid/ask spreads.

A truly liquid ETF also has depth, a dimension created by active trading participants and market makers "layering" the market with interest at multiple price points on the buy and sell side. This layered interest prevents buy and sell orders from "blowing though" the displayed next best bid or offer and executing at a distant premium or deep discount.

The bad news? Electronic trading and a myriad of new algorithmic models and order types make it hard to gauge the type of true depth that helps to prevent price dislocation. The good news? There are ways for longer-term ETF investors, looking to buy and hold funds like MDIV or unload longer term exposure, to get executions that more closely mirror underlying value.

The key is patience. Investors who want to use market orders should break them up into smaller chunks and enter the orders over the course of the trading day. Limit orders placed near NAV can also be effective. If you only get a partial execution, you can cancel your existing limit order, wait, and re-enter a limit order near NAV for the remaining shares later on.

A complex and continuously evolving electronic marketplace, is making it difficult for many traders to gauge depth. As traders adjust to this environment, it is important for ETF investors -- particularly those looking to gain or shed longer term exposure -- to avoid the type of price dislocation that can make funds a much more expensive investment.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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