Commission Free Trading: Is it helping or hurting you?

What are commission-free trades?

Non-commission operations are operations with individual motives or actions that do not involve commissions when executed.

In a Motif trading account, all professional motives and individual stock transactions (outside of created or community motives) are free of commissions when you select the option to trade at the next market opening. The operations of automatic reinvestment of dividends, automatic investment and automatic rebalancing of professional motives are also free of commissions.

With an optional subscription to Motif BLUE, you get three real-time operations without commissions and five operations open in the next market without commissions for reasons built by you or the community per month. Transactions free of unused commissions are not transferred to the following months.

In a Motif Impact account, all exchanges are free of commissions.

Just out of a big increase with a valuable valuation, Robinhood is in the sights of the financial media that are attacking its "free trade" offer. [1] Then the question arises: is this a case of sensationalist journalism?

To try to answer this, let's take a look at how the industry works.
 

How Brokers Make Money

It’s no secret that brokerages have operating costs and have to make money somehow. Broadly speaking, most retail stock brokers operate similarly, and significant drivers of revenue include interest income, commissions, and payment for order flow.

As an example, here’s a snapshot of the 2017 annual revenue contributions by type for TD Ameritrade:

Let’s focus this review on commissions and payment for order flow, which are the hot topics discussed when examining the model of “free trading.”

What are commissions and payment for order flow, and how do they relate to a broker’s business model?

A commission is a service charge paid to a broker in return for executing a trade. Commissions can contribute substantially to a broker’s revenues, as shown in the table I’ve prepared below*:

So how is it that Alpaca, Robinhood, WeBull and others can offer commerce without commissions?

Like the brokers in the table above, they can earn interest income and other account fees. But critics of trade without commissions have highlighted an industry practice called payment by order flow or PFOF. In summary, PFOF is the practice by which retail brokers are compensated by market makers for sending their orders, instead of sending their orders directly to an exchange.

Critics would make you believe that they are sending you to the slaughterhouse; their orders were leaked to high frequency operators who advanced in secret bribery schemes. Serious accusations that would be seriously problematic, but here are the facts:

    The frontal attack is illegal. I realize that laws do not always prevent people and businesses from doing bad things, but ask yourself why a market creation company, which is generally a profitable company [2], would risk your business to advance your retail order ?
    The NMS Regulation guarantees that your order must be completed at a price equal to or better than the best national offer and offer, or NBBO, which is the best price shown available in all exchanges.

Why would a market maker pay your broker for your order?

But if there are no fun businesses, why would a market maker pay his agent for his order and would often give him a better net price than he could get in an exchange in a practice known as price improvement?

Not surprisingly, market makers are willing to pay for their order because on average they can benefit from it. The reality is that the flow of retail orders is more diverse and less toxic than the institutional flow.

As an example, imagine that you send a market order to buy 100 shares of a stock and that this order is addressed to a market maker. The wholesaler who receives your order knows that:

    The average retail order has no further stock behind and, therefore, will not have a significant impact on the price.
    The average retail order is not correlated with the flow of past and future orders.
    The average retail order does not have a positive short-term expectation. (I understand that this sounds intimidating, but this is the case most of the time. Even most professionals do not have a positive short-term expectation for their operations.) A first level infrastructure, a great balance sheet and a strong model forecast are table bets here. Even then, competition and efficiency have squeezed the profits of market makers, and retail orders can be winning operations on any time horizon. In fact, one of the largest market makers, Virtu, previously publicly declared a profit rate of only 51 to 52%.

As another example, imagine sending a limit order not marketable to your broker. This is a passive order that adds liquidity to the order book and is only executed when an aggressive counterpart interacts with it. The wholesaler or his own broker can direct this order to an exchange that will pay them a small refund (fractions of a penny per share) if completed. The agreement to receive refunds for passive landfills and to pay fees for aggressive landfills is the predominant access fee program for US stock exchanges. UU. And it is known as the manufacturer-taker model.

Therefore, the final result is if you are crossing the margin or waiting patiently for it to be filled, the creator of the wholesale market and your broker can generate a small profit on your order, which helps offset your costs and provide your services.

Why pay a commission?

It’s a good question that I don’t have a particularly good answer for.

Brokers have long charged commissions, but as the industry has become more electronic and competitive, brokers have continued cutting commission rates[3] in a “race to zero.” It’s worth noting that most commission charging brokers are double dipping; from the 2017 annual reports of large online brokers, TD Ameritrade disclosed $320 million in order routing revenue, Schwab reported $114 million in order flow revenue, and E*Trade generated $135 million in order flow revenue. So in addition to commissions, they also receive PFOF from market makers and/or rebates from exchanges.

What’s better?

Contrary to what recent articles suggest [1], trade without commissions provides you with a clear and concrete benefit, which is "without commissions."

Should you really be paying $ 5 or more to execute 5 AAPL actions? 1 part of GOOG? Think about that, separate the supply / demand, it's starting at the $ 5 hole, or 0.47%, on a $ 1064.71 purchase of GOOG at the close of operations on 11/15/18. However, things improve as you run high-value dollar operations.

In the example above, imagine that you buy 100 shares of GOOG instead of 1 share. With a price of $ 1064.71 per share and a commission of $ 5, apart from supply / demand, it would start only 0.005% in the hole in an operation of $ 106,471. This seems more palatable, but how often do you expect to make such large exchanges?

So, what is one of the ways in which brokers who charge commissions can gain ground to brokers without commissions in regards to the costs of implementing the trade? As noted, both types of brokers generally work with wholesale market makers, who pay brokers for their order flow. Also noted above, these market makers can provide a price improvement on a customer's marketable orders.

Therefore, for marketable orders, customers can ask if commission collection brokers can provide more price improvements than commission-free brokers.

From my experience, some industry participants have suggested that there is an inverse relationship between price improvement and PFOF. In other words, if customer orders on average receive more price improvements, then that customer's agent will receive less PFOF.

Does the public have data on this? Well, brokers must disclose certain information about the routing of their orders in what is known as a Standard 606 report. This report reveals the average PFOF received from wholesalers.

Usually, this is reported in fractional cents per share, but Robinhood reports this as fractional cents per dollar traded, which leads some critics to make calculations that would suggest that commission-free brokers receive a larger PFOF than other brokers and Therefore, they provide customers with a lower price improvement. But this is only one of the many possibilities. An alternative explanation is that Robinhood's order flow has different characteristics (in terms of the average number of shares traded or the average price of shares) of other brokers, which makes them inform their PFOF in a different way. In fact, this is what Robinhood has publicly stated. However, one thing is clear. There is a lot of competition between the creators of the wholesale market and the retail brokers analyze their execution statistics. However, this leads me to think that we would all be better with more transparency. What you think?

Although some brokers like to promote their price improvement statistics here, they only provide averages and tell you nothing about the amount of price improvement you will receive for a particular order. In other words, if you give your broker a market order to buy 1000 shares of a share when the offer price is $ 31.79 and the offer price is $ 31.80, you are unlikely to know at what price it will be completed. The order: $ 31.7975, $ 31.7982, $ 31.7999, $ 31.80, or any other price between $ 31.79 and $ 31.80 are possible.

If you send this order to E * Trade, Robinhood, Schwab or Alpaca on 100 different occasions, you can get different results every time, without a clear winner in terms of price improvement.

There are many factors, such as the supply / demand differential, the size of the order, the volatility and inventory of the market maker and the risk models that affect the result, and thus calculate its total cost, including the assumption that it can receive the improvement in the average price and the savings reported per operation are difficult and possibly misleading. It is not clear who will provide more long-term price improvements without more transparency.

But there is no ambiguity in the commissions: one is charged or not. I will let you decide if you think the commissions are still necessary or not as part of the broker's business model.
 

How about dropping commissions and payment for order flow altogether and just sending the orders to an exchange?

While some low commission brokers like Interactive Brokers can route your orders to the venue of your choice, routing your orders to wholesale market makers makes them eligible to receive price and size improvements that are unavailable to institutional traders, as well as prevents them from being subject to exchange or venue access fees.

Who are you?

I’m the Head of Trading for AlpacaDB, Inc., and Alpaca Securities LLC (“Alpaca”) is a wholly-owned subsidiary of AlpacaDB, Inc. Like Robinhood, Alpaca is a commission-free brokerage for U.S. stocks. But Alpaca is bringing commission-free trading to a whole new audience — automated traders.

There’s a growing community of software developers, hobbyist coders, and manual traders seeking automation, who could really benefit from a robust, user-friendly commission-free trading API. Whether rebalancing a portfolio throughout the day or trading a large universe of stocks with a limited capital base, automated strategies often trade more frequently in smaller quantities, and such strategies may not be viable if you had to pay a commission on each trade.

We’ve come a long way from the days of fractional spreads, floor brokers, and big commissions. With increasing competition and automation, many would say the cost of trading is being lowered for retail investors and traders.