Stock Market

Why ‘Free Trading’ on Robinhood Isn’t Really Free (Summary)

This article is originally from the Wall Street Journal

Robinhood charges a monthly fee for its margin-lending service, Robinhood Gold. And if you want to move your account from Robinhood to another broker, you must pay $75. Then there’s the cost embedded in stock prices. At brokers like Schwab or Fidelity Investments, when you buy shares, the price at which your order gets filled is generally a little lower than the price of buying those shares on public stock exchanges. Conversely, when you sell shares, the price is generally a bit higher than the exchanges’ selling price.

The difference is often less than a penny. But it adds up for larger trades. Schwab, for instance, says that for orders of 500 to 1,999 shares of S&P 500 companies, the average savings from price improvement is $10.80. Such firms make money by “market-making,” or buying and selling shares all day and collecting the difference between the buy and sell price. That’s risky to do on exchanges, where banks or hedge funds can suddenly snap up or dump many shares, moving their price and hitting market makers with losses. That risk leads market makers to be cautious and quote wider spreads. For instance, they might offer to buy Apple Inc at $200.00 and sell Apple at $200.05, a five-cent spread.

But when market makers trade against individual investors, whose orders tend to be small, they can tighten those spreads. For instance, they might offer to buy Apple for $200.02 and sell it for $200.03, a one-cent spread. That benefits the small investor, because he or she saves two cents on each share. The market maker still makes a small profit from the one-cent spread.

If a customer buys 100 shares of Apple for $200 each—a $20,000 purchase—Robinhood could get up to $5.20 for routing that order to electronic-trading giant Citadel Securities LLC, according to calculations based on a recent Securities and Exchange Commission filing.

Schwab would be paid around 9 cents for sending the same order to Citadel, while TD Ameritrade would get 16 cents on average, according to these companies’ SEC filings. That’s a nearly 60-to-1 difference between what Robinhood and Schwab are paid. The gap isn’t always so wide, because of differences in the formulas used to determine the size of the payments. Still, Robinhood often makes much more for the same orders, the filings suggest.

Summary

Investor places an order for stock through a retail broker such as Robinhood. The retail broker passes the order to a high-frequency market maker. The market maker pays a fee to the retail broker for the order, often pennies per trade. Market makers execute the incoming orders and collect profits by buying shares for slightly less than the price they sell them for, a difference called the ‘bid-ask spread.

Link to Article: https://www.wsj.com/articles/why-free-trading-on-robinhood-isnt-really-free-1541772001

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