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3 Tips for Trading ETFs

Even the cognoscenti among you may find these suggestions useful.

We introduced the Kiplinger ETF 20 last month. Because the process of buying and selling ETFs may be unfamiliar to some of you, we’re following up with some tips for trading ETFs.

Buy commission-free. Because ETFs trade like stocks, you typically incur a brokerage commission whenever you trade a fund. Fortunately, all of the major discount brokerages let you buy and sell certain ETFs without commissions if you trade online. The table to the right tells you which brokers let you trade our favorite ETFs free.

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Use limit orders. Limit orders allow you to specify the price at which you are willing to buy and sell shares. Enter an ETF’s symbol on your broker’s Web site and you’ll see a bid price (the highest price a buyer is willing to pay) and an ask price (the lowest price a seller is willing to accept). Because most of the funds in the Kip ETF 20 are popular, the gap between the bid and ask prices is usually narrow. On one recent day, for instance, the bid-ask spread for iShares Core S&P 500 was just 2 cents, or 0.01% of the share price. But less widely traded ETFs are likely to sport wider spreads, says Max Chen, of ETFTrends.com. For example, the bid-ask spread for Vanguard Russell 1000 ETF (VONE) was recently 0.10%. By using a limit order, you’ll lessen the risk of getting an unfavorable price on your transaction.

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Limit orders can protect you during runaway markets, too. Between 2:40 p.m. and 3 p.m. eastern time on May 6, 2010, more than 300 securities, including many ETFs, traded at prices that were off by 60% or more from their levels before 2:40 p.m., even though the market fell far less. The “flash crash” was a freakish event, but it underscored the need to use limit orders when trading ETFs, especially when markets are volatile.

Watch for pricing anomalies. ETF share prices sometimes diverge from the value of the securities held inside an ETF. When buying an ETF, you want to avoid paying much more than the fund’s net asset value, or NAV, per share, and when selling, you want to make sure that the share price is not far below NAV.

You can eyeball whether a fund is trading at, above or below its NAV by comparing a fund’s current share price with its intraday NAV, known as the intraday indicative value. Go to Morningstar.com and enter a symbol for an ETF. On one recent day, for instance, the intraday indicative value of Market Vectors Vietnam (VNM) was $17.94, but the ETF traded at a share price of $17.78, or a 0.9% discount to the fund’s NAV.

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