Understanding ETF Trading: Key Concepts of Spreads, Volumes, and Liquidity

ETFs trade like stocks. ETFs trade nothing at all like stocks.

Both of these statements are true, and understanding how that can be the case is critical to becoming a good ETF trader.

The bid/ask spread

The place to start with understanding how ETFs trade is to understand how individual stocks trade.

At any given time, there are 2 prices for any common stock: the price at which someone is willing to buy that stock (the “bid”) and the price at which someone is willing to sell (the “ask”). The difference between these 2 prices is called the “spread.”

The reason spreads exist is because, in any open market, folks try their best to negotiate the best prices they can get. If an investor is looking to buy, they’ll naturally want to see if someone is willing to sell for less than the last traded price.

Conversely, if an investor is selling, they’ll naturally hope that someone will bend and be willing to buy it for more than the last quoted price. Spreads are simply the result of buyers and sellers negotiating on prices.

For example, let’s imagine XYZ stock is trading with the bid at $49.90 and the offer at $50.10. The spread is therefore $0.20. If someone asked you what a share of XYZ was “worth,” an investor would probably choose the midpoint, $50.00, or maybe the last price at which an investor can see a trade actually happened.

But if an investor wanted to buy XYZ right now, they would probably have to pay $50.10. If an investor wanted to sell right now, all they would get is $49.90. Those are the prices an investor would get if you enter a market order into your brokerage window.

The wider the spread, the more it will cost an investor to trade XYZ.

Bid/ask spreads are so important to ETF trading because, unlike a mutual fund, which an investor buys and sells at net asset value, all ETFs trade like single stocks, so ETFs trade with bid/ask spreads. That’s the price of the “exchange-traded” in the name.

Spreads widen and narrow for various reasons. If the ETF is popular and trades with robust volume, then bid/ask spreads tend to be narrower. But if the ETF is thinly traded, or if the underlying securities of the fund are highly illiquid, that can also lead to wider spreads.

Overall, the narrower the bid/ask spread, the lower the cost to trade.

Volume and market impact

Bid/ask spreads aren’t the only factor to consider when trading, whether an investor is trading stocks or ETFs. An investor also has to look at volume and so-called market impact.

Volume is the number of shares that trade on any given day. The higher the volume, the better. For example, if XYZ trades, on average, 10 million shares per day, it will be easier to trade than something that trades 100 shares per day. Note, however, that spreads could be tight on both, which could mislead unwitting investors to conclude that both securities are equally liquid.

Typically, the number of shares offered on the bid or the ask will be small—sometimes 100 shares, sometime more, but rarely a huge amount. If an investor tries to buy 10,000 shares of something that only trades 100 shares per day, they could have trouble.

To go back to our XYZ example, someone might be willing to sell an investor 100 shares of XYZ at $50.10, but if they want to buy 10,000 shares, they might have to pay $50.25 or more. The amount that an investor drives up the price of something you are trying to buy is called the market impact.

How does that impact ETF trading, and how are ETFs different?

Because ETFs trade on exchanges like stocks, they have bid/ask spreads, volumes, and potential market impact, too. All else equal, an investor will do better trading something that has high volume and a tight bid/ask spread. In this way, trading ETFs is just like trading a stock.

But ETFs have a critical difference that dramatically alters the playing field for investors.

With single stocks, there is no way to create new shares. If someone wants to buy 10,000 shares of XYZ, they must find another investor who wants to sell. If no one wants to sell, they might have to pay a lot of money to get that trade done.

But ETFs are different: A group of institutional investors called authorized participants (APs) are allowed to create new shares of an ETF to meet demand. So if you want to buy a lot of an ETF—say 50,000 shares—an AP might create those shares to fill your order.

ETF and liquidity

For individual stocks, liquidity is about trading volume. For ETFs, there’s more to consider.

ETFs have 2 layers of liquidity: liquidity of the underlying securities, i.e., the primary market, and the available liquidity in the secondary market. While the factors that determine liquidity are not the same in the primary and secondary markets, both help ensure the orderly trading of ETFs.

On a high level, liquidity in the primary market is tied to the value of the ETFs' underlying securities, whereas in secondary market it's related to the value of the ETF shares traded.

Primary market liquidity

One of the key features of ETFs is that the supply of shares is flexible. In other words, shares can be “created” or “redeemed” to offset changes in demand. ETF creation and redemption is aided by tapping into the liquidity of an ETF’s underlying portfolio of securities.

In the primary market, a specific type of entity known as an “authorized participant” (AP) can change the supply of ETF shares available. The AP can offload a large basket of shares (i.e., redeem) or acquire a large basket of shares (i.e., create) directly from the ETF issuer. Typically, the AP is doing business in the primary market to meet supply and demand imbalances from the trading that happens in the secondary market. Ultimately the primary market helps provide for additional liquidity in the secondary market.

Secondary market liquidity

Most ETF orders are entered electronically and executed in the secondary market where the bid/ask prices that market participants are willing to buy or sell ETF shares at are posted. Secondary market liquidity is determined primarily by the volume of ETF shares traded.

To assess secondary market liquidity, follow an ETF at different times of day, over various time periods, and note how it’s affected by market environments. Some of the statistics you might want to focus on include average bid-ask spreads, average trading volume, and premiums or discounts (i.e., does the ETF trade close to its net asset value?).

Evaluating ETF liquidity

Most investors simply look at secondary market liquidity. But the key point is that both primary market and secondary market liquidity play a role in providing a full picture of ETF liquidity.

Although non-institutional investors tend to trade in the secondary market, retail and advisor investors may benefit from both primary and secondary market liquidity. Here’s an example: If a high-powered investor is placing a trade for tens of thousands of shares, they’re likely to source liquidity through the primary market as an AP fulfills that liquidity demand.

Knowing more about liquidity in the primary and secondary markets may help you evaluate ETFs more strategically.

For individual stocks, liquidity is about trading volume. For ETFs, there’s more to consider.

ETFs have 2 layers of liquidity: liquidity of the underlying securities, i.e., the primary market, and the available liquidity in the secondary market. While the factors that determine liquidity are not the same in the primary and secondary markets, both help ensure the orderly trading of ETFs.

On a high level, liquidity in the primary market is tied to the value of the ETFs' underlying securities, whereas in secondary market it's related to the value of the ETF shares traded.