Getting Efficient ETF Order Executions

The most important thing I have learned for getting good ETF executions is to always follow each ETF's respective index and use it as the basis for making entry and exit trade decisions. For example, if I am trading BBH, the Biotech Index HOLDR, I will always follow and chart $BTK, which is the symbol for the Biotechnology Index. If I am trading SMH, the Semiconductor Index HOLDR, I follow $SOX, the symbol for the Semiconductor Index. If I trade QQQ, I follow $NDX. Get the idea?

I get a much better feel for the true direction of the sector by watching its respective index. Because each sector index is comprised of a more diverse group of underlying stocks than the respective ETF, it is more accurate to watch the index instead because it will trend even smoother than the ETF. The bigger the spread on the ETF, the more important this technique becomes because it gives me a better idea as to where to place my limit order to try to get filled. If I am trying to buy or sell short an ETF HOLDR that has a big spread, knowing the relative strength or weakness of its respective index tells me how good of a chance I have of getting filled if I try to buy or sell short at a better limit price than the prevailing market. Although some of the ETF HOLDRs and Index Funds can be a bit too illiquid for day trading or scalping, they are excellent for the types of multiple-day swing trades that we focus on because getting perfect fills is not as crucial. Let's look at a real live example that occurred last Thursday.

On August 22, one of the plays in The Wagner Daily was to buy OIH (Oil Service HOLDR) if it triggered past a price of 54.80, which it did within the first 30 minutes of trading. As soon as it triggered, I noticed that the specialist widened the spread on OIH, which made it difficult to know at what price to place my limit order to buy. Wanting to be sure if the rally was for real, I quickly consulted a chart of $OSX, the symbol for the Oil Service Index. I immediately realized there was a lot of relative strength in the index because $OSX was consolidating at the high of the day as the broad market was selling off. Therefore, I felt much more comfortable simply paying the offer for OIH because I was confident it was going to go much higher, which it did. By the end of the day, we netted more than 2 points on the trade. However, if I didn't consult the $OSX chart first, I may have never entered OIH because I would not have been as comfortable with paying up due to the large spread.

Let's look at what might have happened if the opposite scenario occurred last Thursday. Suppose that OIH triggered at 54.80 and once again had a large spread. We once again consult the chart of $OSX, but this time notice that the Oil Service index has simply been in a sideways trading range, chopping around, and is not showing much strength. This would cause me to believe that the specialist is just trying to suck in buy orders so he can quickly drop his offer and cover his shares for a profit a few minutes later. If I saw that scenario, I would either wait for more confirmation before buying OIH or place a buy limit order closer to the bid price rather than just paying the offer. In the event I did not get filled, just as well because the sector would not really have been that strong yet anyway. I will gladly pay a higher price later for the increased chance of the trade going in my favor.

While the biggest benefit to following the indexes is in executing less liquid ETFs, I have also found a benefit to watching the respective indexes of even the most liquid ETFs, which are QQQ and SPY. Even though both of these ETFs typically trade with a one to two cent spread, I have found that watching the Nasdaq 100 (NDX) and S&P 500 (SPX) is very beneficial during times of choppiness in the markets because it prevents me from getting shaken out of an otherwise good trade. Here's why. . .

If you watch QQQ and SPY trade on a level 2 screen (which is not necessary if you are exclusively swing trading them), you will notice that both of these ETFs possess a high concentration of ECNs such as Island, REDI, and Instinet on both sides of the market. Although I will get into ECNs in more detail in next week's issue, the main thing I want to make you aware of is that the intraday scalpers and momentum traders will often cause crossed markets with the slightest movement in the market. For those of you who do not know what a crossed market is, in this case it means that the ECN bid will be higher than the specialist's best offer or the ECN offer will be lower than the specialist's best bid. When you see this type of price action, it can often cause you to panic and stop yourself out, even though the Nasdaq 100 futures or the S&P futures may have barely moved. However, if you are watching the actual Nasdaq and S&P indexes instead of the underlying ETFs, you will not be subject to the jumpiness of the ECN traders who often only make a difference of a few pennies anyway. Once you see the actual market index make a solid move, THEN you can make a better decision to take your profits or your stop without doing so prematurely.

The easiest way I have found to follow both the sector index and its respective ETF is to set up a series of charts on your trading software that look something like this:

This is a 5-minute intraday chart that overlays $OSX (the green line) with OIH (the pink line), which allows you to see how one is trading relative to the other. I prefer a basic line chart because it is easier to see convergence or divergence with a line chart. I do, however, use a candlestick chart when viewing only one stock or ETF at at time. I recommend you set up overlay charts with each index and HOLDR so that you can quickly view price divergences (which also illustrate ETF arbitrage opportunities. . .but that's a whole different story). Here is a partial list of ETFs and their associated index symbols to get you started. You may need to check with your data provider regarding the format of the index symbol (some use a dollar sign, others don't):

ETF Symbol	Associated Index Symbol
QQQ	$NDX
SPY	$SPX
DIA	$INDU
SMH	$SOX
BBH	$BTK
OIH	$OSX
PPH	$DRG
SWH	$GSO
RTH	$RLX

Types of orders and optimal routing

Throughout this article, I have made the assumption that you have a brokerage firm who offers you a choice in how you route your order (primary market, third market, or an ECN such as Island). However, if you have a web broker who simply executes your order without the ability for you to choose the best route, there are still some ideas contained within that will assist you in getting better prices on your order fills.

Market or Limit?

As a general rule, I use market orders for executing both buy and sell orders. My philosophy on this is simple -- It's better to get a bad fill and catch an 80 cent move in your direction than to miss getting filled by 5 cents and watch the trade go run 85 cents without you in it. Remember that I am typically looking to make 1 - 2 points of profit from most trades I enter and am usually in the trade for anywhere from 1 - 3 days. I don't trade with the intention of profiting from nickels and dimes, so I also don't worry about them when trying to get filled on an order. This is a lesson I have learned from my mistakes of the past when my insistence on getting a good fill continually caused me to miss substantial profits. I soon learned that being stubborn by using tight limit orders is not as profitable as simply trying to get an average-priced execution over the long-term. I know some traders will disagree with me, but this is what I have learned the hard way through years of personal experience and it is what works best for me. All that being said, there are indeed some instances when I do use limit orders on ETF trades.

The biggest factor that determines when I use limit orders is the liquidity of the actual ETF because some trade with much tighter spreads than others. In general, the more liquid a particular ETF is, the more likely I am to use a market order. Since high liquidity ETFs generally trade with a spread of only one to five cents, I usually get good fills with market orders and don't have to worry about chasing the price for pennies. However, when an ETF is illiquid, the spread will typically widen in correlation with the reduced liquidity. In those cases, I prefer to use a limit order. There are presently 21 ETFs that trade an average daily volume of 300,000 shares or more, which constitutes the entire realm of securities that I trade. However, there are 10 that I frequently trade. The list below shows whether I usually use market or limit orders on those 10 ETFs. There are always exceptions, but this list constitutes the type of order that I use a majority of the time:

Market Order	Limit Order
QQQ	BBH
SPY	OIH
DIA	PPH
SMH	RTH
	MDY
	XLF

With the less liquid ETFs that I have listed above, I have found the best strategy is to place your order either slightly above or below the middle of the spread, depending on whether you are trying to buy or sell. If I am buying, I place my order about 5 cents above the middle of the spread and place it 5 cents below the middle of the spread if selling or selling short (remember there is no uptick rule). For example, let's assume I am trying to buy BBH when the best bid is 83.20 and the best offer is 83.80. Assuming it is not a fast-moving market, I would probably place my limit buy order around 83.55. However, in a fast-moving market, I would place my order a little higher, maybe even go with a market order if I felt confident it was about to run a few points. Remember my goal is not to catch every single cent of a move, but just to catch a good piece of the move with minimal risk.

Order Routing

There are basically two choices with regard to how to get your order filled. The first choice is through a stock exchange such as the American Stock Exchange (AMEX) or the New York Stock Exchange (NYSE). The other option is to place your order through an ECN (Electronic Communications Network). For those of you who don't know, an ECN is simply an electronic network of computers that allows traders to trade directly with one another instead of via a stock exchange. This results in faster, and usually cheaper, order executions. The ECNs that trade the most ETF volume are ISLD, REDIbook, and Instinet.

Because of the speed of execution, I generally prefer to use an ECN for order execution. If I am trading QQQ, SPY, or DIA, I usually execute on Island. In fact, Island is rapidly becoming the standard execution choice for most traders who trade any of the ETFs. As of the time of this writing, Island trades 36% of the average daily volume in QQQ. This represents more than the combined percentage of both the NYSE and the AMEX! Island also executes approximately 33% of DIA volume and 25% of SPY volume. Although ECNs offer the fastest and most reliable method of execution, I have learned that there are times when executing your order through the AMEX is more profitable than through an ECN such as Island.

When an ETF has been trending all day and it suddenly reverses direction, you will notice that the inside market for Island and the other ECNs rapidly changes. However, due to the slowness of the specialist system, it often takes the specialist longer to update his inside market prices than it does with an ECN. You can use this lack of speed to your advantage if you need to get out of the position by immediately placing a market order to close your position. Although there are going to be times when you occasionally get a bad order fill, I have found that I usually get a better fill through this method than if I would have joined the inside market on an ECN. More importantly, I am assured of getting out of the position. The most recent example of this happened to me last Thursday when I was short SPY before the big morning reversal. As soon as the S&P Futures spiked up, traders on ISLD immediately jumped above the inside offer of the AMEX, creating a crossed market. I knew that if I executed on Island, I would have paid up quite a bit. So, I placed a market order to buy on AMEX and got filled at a price that was at least 10 cents better than what I would have paid if I executed through Island. This has happened to me on many occasions, but primarily as soon as a market has reversed directions and the ECN traders have created a crossed market.

On a final note for those of you that have access to Level II quotes, I strongly recommend setting your Level II box to highlight the AMEX, as opposed to NYSE because AMEX typically leads the market with most ETFs. You will often notice that the third party exchanges such as BSE, CIN, PHS, CBO, and NAS are slow to update their quotes and often will show an inside market price better than AMEX or NYSE. However, you will rarely get filled at those prices. Although NYSE is the big daddy in the world of stocks, I have found they are rarely on the inside market of most ETFs. Instead, AMEX leads the inside market because ETFs are issued on the AMEX. Therefore, with regard to the two biggest exchanges, you will typically get a better and faster fill with AMEX than through NYSE when it comes to executing ETFs. Bear in mind, however, the exact opposite is true when executing a traditional stock of just one company.

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