By Gary Brooks, CFP®
Each time we execute a transaction to buy or sell a security in a client’s account, our custodian – Charles Schwab – generates a confirmation notice for the client. Sometimes, we receive questions on the information provided and the timing associated with various types of trades. To help clarify, here are important ideas to understand about trading.
Trades broken into multiple groups of shares creating a long transaction confirmation
When buying or selling shares of exchange-traded funds (ETF) or individual stocks, the amount of shares we want to buy or sell doesn’t always move in one complete lot. For instance, to execute an account rebalance, we sell 550 shares of the Schwab U.S. Broad Market ETF (SCHB). It’s possible that a single party will be involved on the other side of the trade and will buy all 550 shares at the same price in a single transaction. But this doesn’t happen often. Sometimes, the trade confirmation statement will show a dozen or more individual transactions were done to complete the sale of the 550 shares. Occasionally, even groups of just a few shares will trade. We enter the trade and the electronic exchange pairs asking prices with bid prices to link the buyer and seller. Regardless of how many pieces a trade is broken into, if it is entered as one lot of shares, the transaction price remains the same no matter how many segments it is split into.
Limit orders vs. market orders
When trading ETFs or individual stocks, we have a combination of restrictions we can choose to use or not. We can choose between limit orders and market orders and if we choose to use a limit order, whether we want the trade offer to expire at the end of the day or be left open until otherwise cancelled.
Limit orders allow us to establish a specific price at which we are willing to buy or sell. Depending on the amount of trading volume for the security being traded, the difference between bid and ask prices amongst sellers and buyers can vary greatly. In stocks or ETFs with high trading volume, the difference is often only a penny per share. In less-traded stocks or ETFs the spread between prices can grow.
We typically place limit orders so that we have some control over the price target. This is also why we prefer to buy and sell securities that have enough shares trading each day to create a liquid market.
Limit orders can have drawbacks. If a specific buy or sell price target is entered but the market moves quickly before a transaction is completed, you may have to revise your buy or sell price to readjust to the market so the transaction will take place.
Market orders, on the other hand, simply match the position being offered or requested with the next available shares executed immediately at the current market price. On the plus side, your trade has a high(er) chance of going through. On the negative side, you have little control over the buy / sell price.
When an ETF or stock is bought or sold, even if the activity happens immediately, it takes an additional 3 days before the cash involved in the transaction is cleared by the custodian. In some cases, it’s preferable not to be out of the market for three days. When a mutual fund is bought or sold, it takes just one day for the transaction to clear.
This can create a complication when selling out of an ETF or stock with the intent of using the proceeds to buy a mutual fund. If you sell the ETF or stock on day 1, you would have to wait three days so that the necessary cash is available to buy the new mutual fund. Depending on what happens with market returns over those couple days, there is potential that the timing of the transactions could impact your portfolio’s return compared to a benchmark. It’s not uncommon for stock markets to move more than 1% in a single day. A quick 3-day rally would present a missed opportunity cost as part of the transaction. Of course, the markets can also go the other way. And over very short periods, it’s just slightly more likely than 50/50 that a one-day stock market return will be positive. Sometimes, being out of the market for a couple days while trades clear is a benefit because you can make the next purchase at a lower entry point.
If the intent is to replace a mutual fund with another mutual fund, since both transactions would clear the following day, you could execute the sell and the buy on the same day. The challenge here is if you intend to invest every dollar of the sale proceeds into the subsequent buy. Since mutual funds are only priced at the end of the trading day, you don’t know exactly how much the sold shares are worth until the following day. Therefore, if you place a buy order the same day as the sell, you must be sure to buy a little bit less of the new fund than you expect to receive from the sold fund so that the account doesn’t end up short of cash.
Occasionally, we will decide to move out of an investment for all clients that hold the same position. If this is true with a mutual fund, it’s no problem because everyone receives the same end of day price. But if we trade out of an ETF, for example, there is risk that not each of the clients would receive the same transaction price if all the trades were entered individually. Even if we submitted them all at the same time, there’s no guarantee all shares would trade at the same price, because it depends on what is being offered on the other side of the trade. To be fair to all clients, we add up the total number of shares of the holding from all our clients that we want to trade. We trade all those shares and then allocate the transactions and price execution back to each client equally.
Trading individual bonds
The bond market is far less transparent than the stock market. It’s more difficult to monitor bid and ask prices for individual bonds. This is part of the reason we don’t hold many individual bonds for clients. When we do – or we receive individual bonds as an incoming transfer for a new client – we work with the Schwab trading desk to reach out to market makers for offering prices. This is less efficient and sometimes it means that trading individual bonds requires making a concession on price in order to find a buyer. This is more likely the case with very small bond holdings (i.e. less than $5,000 per bond).
Once in a while, we will intend to sell all shares of an investment but after the trade is completed, a small number of shares show up in the account. This happens with funds that pay income or stocks that pay dividends. If a sale happens close to the date of an income/dividend payment and the holding was designated to reinvest income payments, even though the previously existing shares were all sold, the income/dividend reinvestment will continue and a new fractional position in the fund will return in the account.
This is usually cleared up with a call to our service team or simply another trade to clean out the extra shares, converting them to cash. These housekeeping trades do not generate transaction fees.
Buying and selling the same position
It doesn’t happen often, but sometimes, we may be buying a fund for one client and selling it for another on the same day. This could happen if one client has a need to raise cash or rebalance a portfolio while another client is investing new cash or rebalancing in the opposite direction. We do not have any ability to match these transactions or gain any favor for either investor by exchanging shares outside of standard trading procedures on an exchange.
This covers the most common trading functions. Of course, there are several activities and options available. Regardless, it’s important to keep in mind that every trade has a buyer and a seller. This is a zero-sum transaction. While one party is willing (happy?) to sell at one price, the buyer is just as happy to hold the shares at the same price.
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