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When Robinhood started off by pioneering commission-free trading in 2013, it looked like a joke to established stockbrokers. Now, zero-commission stock trading has gone mainstream and many more investor-centric innovations are underway.
While the rave about trading stocks for absolutely free remains, you should know these three important facts about the innovative banes to traditional stock trading.
Related: Personal Finance: Free Stock Trades
It was a defense strategy
No doubt, Robinhood entered the industry with an excellently crafted Unique Selling Proposition (UPS). Five years after its inception, in 2018, Robinhood had 6 million active users.
Their rapid growth spurred the concerns of other major players in the industry. So much so that Charles Schwab, the biggest stock brokerage firm in the US, announced its zero-commission trading proposition in October 2019.
Analysts suggested that Schwab dropped its fees to zero to retain users and compete against the fast-rising Robinhood. However, investors were not entirely happy with the announcement back in 2019. Nevertheless, this defense strategy may seem juicy to users but stockbrokers have found a way to make more money by charging you less.
Now, they make more money from you
Before introducing zero-commission trading, Charles Schwab made $139 million in 2018 from trading commission alone. But in 2020, while they charged no fee from traders, they made $245 million from their trading activities through a process known as Payment for Order Flow (PFOF). That’s over 76% more than they made from trading commissions.
Payment for Order Flow means that while they charge you nothing for filling trade orders, they scratch a few pennies from your trades by routing the order through market makers, like Citadel Securities. They do so by capitalizing on the ask-bid spread. For example, a market maker can concurrently fill a BUY order at $50.45 and a SELL order at %50.30 without going through exchanges, even though the Bid/Ask on the stock exchange ticker for that same stock showed $50.50/$50.20. A significant portion of the $0.15 difference in the transaction is paid to the brokerage (e.g. Charles Schwab and Robinhood) as Payment for Order Flow.
While traders are happy to have sold higher than the market’s best Ask (or bought lower than the market’s best Bid), the trade never actually went through the stock exchange.
And they are innovating further
Stock brokering is a numbers game. The more contracts filled, the more money the broker would make, commission or not. To encourage more trading, innovative stockbrokers are offering fractional stock trading.
With fractional stock trading, you can own a fraction of a share if you can’t seem to afford a whole unit of that share. For instance, you can own 0.01 units of a $100-per-unit share. Robinhood and Charles Schwab allow their users to own fractional shares while E*Trade, another top stockbroker, has shown no sign of falling in line.
Some final words
Since the COVID pandemic, E*Trade reported that Millennial and Gen Z investors are taking insanely high risks and trading at unusually high frequencies through commission-free stock brokers. This increased frequency provides greater money-making opportunities for zero-commission stockbrokers through PFOF. Also, with the fractional share offer, beginner day traders with very low capital can join the rally and drive it further down the line until another innovative idea goes mainstream.