Is it really free?

There has been a lot of talk lately about commission-free trades by some firms. Now, I like free stuff as much as anybody, but is “free” really free? You need to know about this. There are a number of firms jumping on this bandwagon, and one that has been in the news a lot for about three years is the online brokerage firm Robinhood. Many others are doing the same thing, but Robinhood seems to be getting the most publicity.

Don’t get me wrong. I have nothing against Robinhood and don’t know or care a lot about them. I would imagine they are a good firm and they do what they do well. Additionally, I generally don’t operate my business on a commission basis, so it doesn’t really matter much to me. I’m not suggesting what you should or shouldn’t do with respect to commissions, but I think it is worthwhile knowing the whole story so you can make an informed decision.

Lately, the U.S. Securities and Exchange Commission (SEC) has been scrutinizing their business model, and reasonably so. The brokerage firm has attracted millions of users and continues to attract investors by offering trading without commissions.

Zero trade commissions! Aren’t commissions how brokers make money? What’s the catch? As I’m often reminded, nothing is free on Wall Street. Robinhood still needs to make money as a business. In fact, all businesses need to make a profit somehow, or they will soon be going out of business. There is nothing wrong with earning a commission or a fee for doing what you do as long it is fair and fully understood, and I’m not suggesting that any of them are doing anything wrong. So, how do they and others offering “free” trades make money?

Everyone is somehow paying for their “free” trades. Professional investors evaluate brokers on both commission costs and trade execution quality. They’re willing to pay a little more for better quality trade executions (By execution, I mean the price investors pay for the trades they want. The more favorable the price and the speedier the transaction, the better the execution).

Individuals, on the other hand, (unless you’re a billionaire trader) often get fixated on commission costs. That’s where Robinhood has the opportunity to generate profits; they promise $0 commissions on stock and options trades.

How does Robinhood make up the difference? By selling what is called “order flow.” Robinhood takes all the trade orders from its clients and hands them over to a Wall Street firm to execute the trade. But, the trading firm will take the trade only if they can make a profit after paying Robinhood for the order. The customer gets a trade confirmation for the price paid, but they don’t really know if that was a fair price or not.

Those profits from trading have to come from somewhere. They’re pulled from Robinhood customers who placed the order and didn’t see the costs. The only way for Robinhood to come out on top of this situation is if it’s giving a better execution price to Wall Street than it is to its clients.

So, in short, Robinhood does have a kind of “trading commission.” It’s just that these costs are hidden in the execution quality. That means the customer paid a few cents more per share (or maybe a few dollars more) per options contract so that they could receive “free commissions.” Had the order been placed at another brokerage firm, then maybe the execution quality might have been better, even at others that don’t charge commissions. The problem is that there is no way for you to know.

Execution quality is your real friend. Remember, brokers can still make money by offering high-quality execution with low or no commissions because they generate money in other ways. That includes making money off the cash balances in an account through stock lending or through other means that don’t affect the quality of trade executions.

The difference in execution quality can be small, but it can also be large, especially in options. Even a $5 commission can be less expensive than a poorly executed trade. The problem is you likely won’t even know. That’s why market pros look at execution rather than costs. Individual traders who want to play it smart should, too.

Is this a big deal? Maybe, maybe not. But, it can certainly add up. By now, I hope you have a better idea of how a brokerage firm can help you get the most out of your trades, or how it can leech profits from your portfolio over the long term with hidden costs.

Picking the right broker or financial advisor for your needs is important, regardless of your level of trading experience. Again, I am not saying any firm that offers commission-free trades is doing anything bad or inappropriate, but before you get glassy-eyed over the word “free”, I am just saying that nothing is ever really “free,” and you should understand what and how you’re paying for the service.