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Investing basics: best practice for trading securities in volatile markets

James Gard with Emma Rapaport.  |  01 May 2020Text size  Decrease  Increase  |  
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Plunging stock markets have sent many investors, professional and amateur, running for cover. But those brave enough to continue trading in these volatile market conditions can take some simple steps to protect themselves.

Here we run down the basic options for investors who are buying or selling securities.

Don't just choose the default

When you trade “exchange-traded instruments”—shares, investment trusts and ETFs—through an online broker, whether you want to buy or sell, you are offered the choice of “market order” or “limit order”.

Many people would choose “market order” because it’s simpler and is usually the default choice. With this option, you are given a quote based on the current price the investment is trading at and a breakdown of charges. Typically, you are given only a short time (around 10 seconds) to accept the price or not before it updates. “Investors tend to use market orders in instances where time is of the essence and price is of secondary importance,” says Ben Johnson, Morningstar’s director of global ETF research.

If the market is closed and a price isn’t available, orders are executed “at best”, i.e. your investment platform will try to get the best price. In highly volatile markets, this can be risky in the extreme—especially with many markets plunging at the open.

If you advise your broker to trade "at best" you are likely thinking that you will get something close to the closing price. But if the market plunges as it opens, the best price that the broker can achieve can be much lower than you expect. If there is a wave of sell orders at the open, a buy price is often difficult to achieve.

Should you use a limit order?

A limit order introduces an element of control over the price you pay for an investment. These allow you to set the maximum price you want to buy at or the minimum price you want to sell at. If the price is met the trade goes through, if not the trade expires at the next market close.

Limit orders are free and easy to set up. Deciding on the price is the harder part; in volatile markets it makes sense to build a bit of a buffer for market moves up and down. Market experts suggest that around 20 per cent either side of the current price is a sensible yardstick.

In falling markets, you are protecting yourself by saying effectively—"I won't sell share x for less than x", which is useful if the price plummets.

In rising markets, you won’t pay more than the price you specify if the share soars. While this may seem a remote scenario at the moment, as our research shows, market falls are often followed by very strong rebounds.

“Limit orders will ensure favourable execution from a price perspective,” says Johnson. But the trade-off is that you often have to wait longer to get the price you want.

Use limit orders for ETFs

Johnson advises that investors should use limit orders when trading ETFs. For very large, very liquid ETFs, that trade at the same time as their underlying securities, he says market orders will likely result in fast execution at a good price. However, many exchange-traded products on the market are smaller and less liquid than this ETF and may also trade out of sync with their constituent securities.

"In all cases, using limit orders is good practice," he says.

Johnson says limit orders will ensure favourable execution from a price perspective.
"What is the potential cost of using limit orders?" he asks. "Time and incomplete execution. That is, it may take longer for a limit order to be filled than a market order, and when that time comes it might not be completely filled.

"These costs need to be weighed against the cost of being exploited by an opportunistic market maker looking to pick off market orders in thinly traded ETFs."

Trade when the underlying market is open

If you are trading an ETF that invests in securities that trade in markets outside of your time zone, Johnson says it's best to trade the associated ETF when its constituents are actively changing hands in their home market.

"If you trade when the overseas market is still open, for example in the US, it is easier for market makers to keep the ETF price in line with its NAV, as the stocks in its portfolio are still being bought and sold in real time," he says.

For markets where there is no overlap with the Australian market, Johnson says this is where, limit orders come in.

Don't trade near the open—or the close

Lastly, Johnson says it's best to avoid trading ETFs just after the opening bell. This is because ETFs may take a while to "wake up" in the morning.

"For a variety of reasons, it takes some time for all of the securities (assuming they trade during normal market hours) in their portfolios to begin trading," he says.

"Before all of an ETF's constituents are trading, market makers may demand wider spreads as compensation for price uncertainty."

It's also a good idea to avoid trading ETFs as the closing bell approaches.

"As the market winds down toward the end of the day, many market makers step back to limit their risk headed into the close," Johnson says. "At this point, spreads tend to widen as there are fewer actors actively quoting prices.

"In light of these considerations, it makes sense to wait about 30 minutes after the opening bell to trade an ETF and to avoid trading during the half hour leading into the market's close."

 

James Gard is content editor for Morningstar.co.uk. Emma Rapaport is an editor for Morningstar.com.au.

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