Building An ETF Portfolio: Using Limit Orders vs. Market Orders

In recent years, Exchange Traded Funds (ETFs) have been growing in popularity when building an investment portfolio. You can buy them from any discount broker, they have no minimum purchase amounts, and offer lower expense ratios than their mutual fund equivalents. Here are some sample ETF portfolios. On a case-by-case basis, I’ve been switching over some of my holdings from mutual funds to ETFs. But a practical question arises – Do you buy them with market orders or limit orders? This is in the context of buying and holding ETFs for a certain asset allocation, not for active traders.

Briefly, a market buy order is a request to buy an ETF at the best price available at that instant that someone else is selling it for. It will usually execute virtually instantaneously. On the other hand, a limit buy order is an order to buy a specific price or lower. If you can’t get that price, it will not execute. (There are more order types, but these are the only ones I use on a regular basis.) Limit orders are useful in IRA or 401k accounts when you have a set amount of money to work with.

Why I Always Use A Limit Order

Let’s say you want to buy an ETF like Vanguard Total US Market (Ticker VTI). If you pull up a quote, the big number they will show you is the last traded price along with a bid/ask. Let’s assume the last trade is $60 a share, and the bid/ask is $59.90 and $60.40. That means at that instant, someone says they will buy X shares at $59.90 (bid), and someone else will sell their shares at $60.40 (ask).

If you put in a market order and nothing changes in the meantime (computers are constantly trading every millisecond), then you’d end up buying shares at $60.40. However, there is a chance that those shares will be sold already, and nobody else is selling at that moment except for someone who wants $75. Not a high chance, but not zero. Then you’d be stuck buying at $75.

Alternatively, you can put your limit order for whatever price you like, and see if it hits. Now, what if you put a limit order above even the current ask? You’re basically saying, I want to make a purchase right now, and I’m willing to pay a certain amount more if absolutely required. Let’s say you use a limit order at $61, a small 1% premium to the last ask. My fear would be, would someone out there see that and sell me shares at $61, even if I could get them at $60.40 or even lower? According to this Schwab.com article, you won’t be taken advantage in such a way of because such action would be illegal:

Markets are not allowed to fill orders at a price worse than the market price, even if your limit order allows for it. Building in a little extra room to ensure your order is filled will not cause you to overpay—you should still be filled at the prevailing market price when your order comes to the front of the line.

This is called “best execution”. According to this SEC article, the quality of trade executions are constantly being monitored, even on a stock-by-stock basis.

In my own personal experience, I have entered many limit orders above the market price, and my fills are usually shy of my limit price and the same as market or lower. Even though I could have easily been ripped off, I wasn’t. As a result, I don’t bother with market orders. I just use a limit order, usually with a buffer, and I get protection from a price spike or “flash crash” situation and being stuck with a horrible fluke price, while at the same time my order is likely to be filled quickly at a price no worse than a market order.

How To Choose Your Your Limit Order Price
Okay, some how much buffer do you put in? It depends on what your personal requirements are. Maybe you only want to buy at a set price, so you don’t need a buffer at all. If you really want to make a purchase today and just want to enter one order and be confident you’ll get the shares, you could add anywhere from 0.5% to 5% on top of the current market price. If you really want to make sure you get the best possible price at the exact moment you’re staring at the ticker, you can simply enter a limit order somewhere between the bid/ask spread. However, you run the risk of the price inching higher and ending up having to pay more later. According to the Schwab article above, your chances change with the size of the spread:

The wider the spread, the greater your chance of order execution between the bid and ask. The reason a market maker may be more willing to lower the ask or raise the bid in order to trade with you is that he or she knows that investors are less willing to trade at the market price when the spread is wide. By contrast, when the spread is $0.05 or less, it will be more difficult to trade between the bid and ask. In such cases, you may want to consider a limit order at the bid or ask, since shaving a penny may not be worth the risk of the order not getting executed.

Finally, the time of day matters. The time periods right when the market opens and right before the market closes are known to have higher volatility. For buy-and-hold investors, you may wish to avoid this time if possible.

Comments

  1. I always check the Intraday Indicative Value of an ETF in a separate browser window just before I enter my limit orders, and make that my target price. For example, your VTI can be found here: http://www.google.com/finance?q=INDEXNYSE:VTI.IV

  2. Thanks so much for the super helpful article. I’ve been feeling a little lost in my switching from mutual funds, where this is not an issue.

  3. Enonymous says:

    Realize though that all of our little above market limit orders are seen a split nanosecond earlier by the hft algorithms
    If there are enough of them, they can front run your purchase and raise your effective execution price.

    We may not ‘see’ the difference and that is the insidious nature of hft.

    I still will always use limit orders much as you describe, but I also know my execution would have been better without hft.

  4. HFT (high frequency trading) can take a peek at your bid price. If it’s above the current market price, the machines will probably buy at the current market price and sell you the shares at your bid price.

  5. 1) At what point ($ amount or %) do you decide to convert your Mutual funds into the equivalent ETFs?
    2) Are there no tax implications (in a taxable account) for the conversion?
    3) After conversion, do you periodically execute manual ETF trades at a regular frequency or continue with periodic (automatic) mutual fund buys and then convert again to ETFs when the amount is substantial?

  6. personally, I feel that for high volume stocks/ETFs, it doesn’t really matter if you use limit or market orders. on the other hand, if you’re dealing with low volume or penny stocks, then you better use limit orders

  7. high volume = doesn't matter says:

    I totally agree with Bucky. VTI (using this example) is penny/peanuts with the spread. Maybe i’m just misunderstanding things but $59.90 and $60.40 bid/ask for VTI is unheard of. :/

  8. Nice article. Yes, limit orders are defintely the way to go. You’re probably not going to have much issue with a market order on an ETF, but there’s nothing wrong with being extra cautious.

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