Exchange-traded funds and stocks have some similarities and differences. ETFs are traded like stocks on the exchange but are not quite similar to stocks. Thus, understanding spreads and volumes becomes a top priority for us.
Understanding spreads
Spread, often called the bid/ask spread, is the most fundamental thing to know while operating in the stock market.
Stock markets can be seen as ‘meeting sites’ for investors, with each investor looking to get the most out of a transaction. At any given time in the market, there are two prices: the sale price, i.e., ‘ask,’ and the other to buy, i.e., ‘bid.’
Buyers of ETFs aim to pay a fair price and, if possible, a discount on the market price of the core securities in the ETF, while sellers want to get the highest price for their units when they sell on the exchange.
In an open market, traders try to broker the best deal possible. This is the reason why spreads exist. A transaction occurs when both parties agree on a price and exchange ETF units.
Let’s understand with an example if a trader wants to sell some ABC corporation shares in the open market and some traders want to buy the same ABC corporation shares.
The price is $25.75, whereas the bid is only $25. Thus, the absolute difference in these prices is the spread. Here the spread is $0.75. The prices should converge at some point for the trade to get executed.
If a trader wants to purchase at the moment, he has to pay the asking price, in this case, $25.75.
Trade cost increases if the spread is wide. The bid/ask price plays a pivotal role in ETF pricing as these are traded in the same fashion as our ABC corporation stock.
Bid/ask spreads are generally tighter when an ETF is hot and trades in large volumes. However, larger spreads may result if the ETF is sparsely traded or the fund’s underlying securities are highly illiquid. Overall, the smaller the cost of trading, the tighter the bid/ask spread.
Although the bid and ask prices of an ETF will roughly resemble the value of the securities held by the ETF, bid-ask spreads might vary based on a variety of circumstances, including
- Spreads on underlying assets: The underlying asset class’s liquidity determines the ETF’s liquidity. As a result, if the underlying equities are very liquid, it implies that the ETF will be similarly liquid, with a minimal spread.
- Cost of accumulating securities and trading the ETF: The cost of putting together and trading the ETF’s basket of securities may impact the spread. For example, there will be additional charges to convert local currency to the underlying currencies if the ETF invests in overseas securities. Another scenario could be regulatory charges and taxes for overseas assets in compliance with local trading regulations.
- Trading volumes: We will understand this in detail below.
- Involved market risks: During higher market risk or volatility periods, bid-ask spreads can also inflate.
Understanding volume and market impact
The bid/ask spread is not the only factor to be cautious about while buying ETFs. Trading volumes also play a major role in determining the ETF’s spread and overall liquidity.
The quantity of shares traded on any particular day is called volume. It is preferable to have a bigger volume. If ABC Corporation trades 20 million shares daily on average, it will be better to trade than if some corporation only trades 500 units daily.
However, keep in mind that spreads on both may be tight, leading investors to believe that both assets are similarly liquid. Thus, treading cautiously is the key.
The number of stocks offered on the “bid” or “ask” is usually small, say ten shares, sometimes more, but seldom a large number like say 50000; if such is the case, then the ask itself will drive up the bid.
Logically, the more the demand, the more the price! This very phenomenon is called market impact.
Since ETFs are similar to stocks, they are affected by volume and spreads. However, the market impact on an ETF is minimal due to the very nature of the ETF.
If there is a great demand, then the AP can create more ETF shares with the help of underlying securities to cool off demand and the rising market price compared to the underlying NAV. Thus, an ETF is not affected by market impact with the severity of a stock.
FAQs
What is the bid/ask spread?
The bid/ask spread refers to the difference between the highest price at which a buyer is willing to purchase an asset, called, the bid price, and the lowest price at which a seller is willing to sell it, known as the asking price.
In financial markets, including the context of ETFs (Exchange-Traded Funds), the bid/ask spread represents the gap between the maximum price a buyer is willing to pay for an ETF and the minimum price a seller is willing to accept.
It is essentially the cost of executing a trade and serves as a measure of liquidity and market efficiency.
What is the relationship between ETF liquidity and underlying asset liquidity?
An ETF’s liquidity has a close association with the liquidity of its underlying asset class. The liquidity of an ETF depends on the level of ease with which its underlying assets can be sold or purchased in the market.
For instance, if an ETF tracks a highly liquid asset class as large-cap stocks trading actively on major exchanges, it is more likely to exhibit higher liquidity in comparison to an ETF tracking a less liquid asset class, such as small-cap stocks.
The underlying assets’ liquidity directly impacts the ETF’s liquidity, determining the ease and availability of executing trades in the underlying securities, which in turn affects the bid/ask spreads and also the overall readability of the ETF in the market.
How does the trading volume affect bid/ask spreads?
The impact of trading volume on bid/ask spreads is significant. In general, bid/ask spreads tend to be narrower and more favorable for traders when an ETF experiences high trading volumes and is considered “hot” in the market.
This is because increased trading activity implies higher liquidity, as there are more buyers and sellers actively participating in the market, resulting in tighter spreads.
In lieu, if an ETF lacks significant trading volume, or is thinly traded, bid/ask spreads may widen, making it more costly to execute trades. Additionally, bid/ask spreads can also be influenced by the liquidity of the underlying securities held by the ETF.
If the underlying assets are illiquid or have low trading volume, it can contribute to wider spreads.
