This podcast covers the industry’s shift towards a commission-free trading model for stocks, how the big brokerages are really making money, and if it has any impact on futures traders.
It’s Matt Z, and I wanted to share with you some of the latest news that has happened in the Stock industry. We had an avalanche of stockbrokers going to the ZERO commissions model.
We are going to discuss that, explore how money is made in the stock industry through Order Flow, and then discuss what the implications for the Futures industry are.
On September 26th Interactive Broker introduced IBKR Lite. IBRK Lite is a cost-free way to trade US exchange-listed stocks and ETFs for traders who do not wish to consider our efforts to obtain greater price improvement through our IB SmartRouting℠ system.
So what is a routing method?
According to SpeedTrader: “These programs will automatically scan the various pre-determined ECNs for the best price and liquidity and spread out the order until filled. Some direct access brokers go one step further and allow the users to select a preference of routes in the preferred order for their smart routing. This allows for the best liquidity situation but may take a bit longer due to the extra time to scan the ECNs. The time difference may not be noticeable in terms of an extra second or two, but high frequency trading ( HFT) programs operate in single-digit millisecond. Compared to the HFTs, even a single second is an eternity.”
So essentially, in stock trading, you can choose to execute your trades on the exchange that lists the stock or stock options.
About two weeks following the announcement of Interactive Brokers we had three significant brokers announce that their commissions are going to zero.
This could not be a coincidence because every customer must have called their brokers with the same question: “What about you?” This all happened during the week of 1-4 of October 2019.
From the news:
- Charles Schwab acted as the catalyst for this latest wave of price cuts across the industry. As one of the largest and most respected brokers, Schwab announced on Tuesday that they would be ending commissions for trades on stocks and ETFs, slashing fees from $4.95 to zero for these securities. On options trades, it also cut its base commission from $4.95 to zero, but traders will still pay $0.65 per contract.
- TD Ameritrade followed suit later in the day, ending its $6.95 commissions for stock and ETF trades. It followed Schwab’s move on options, too, cutting its base commission to zero and lowering its per-contract fee on options trades to $0.65.
- Rival E*Trade joined the fray the next day, slashing its $6.95 commission on stocks and ETFs to zero. It also trimmed its base commission on options trades to zero and slashed its per-contract fee on options trades to $0.65, matching its other big competitors.
- TradeStation did the same after.
That week the stocks of these companies plummeted. Why?
- Loss of revenue
- Now they are relying on the exchanges to pay them money, not their customers. We will get to routing compensation shortly.
Who instigated all of this? RobinHood. I am NOT going to talk in-depth about RobinHood, the app for stock trading with zero commissions that was established in 2013.
But, Robinhood is NOT only a broker; they are also app > A MOBILE solution for the millennials.
Were they the original commissions free, no! There was another before them like Zecco that was purchased by Ally, so clearly, zero cost commissions were not as popular until Robinhood entered the space. But, when Zecco was created, the use of phones (mobile)for trading was not as prevalent.
Robin hood works on a skeleton crew. This means that one person does what 10 people do in other traditional brokerages. In my opinion, layoffs are coming to all the traditional brokers. That’s beside the point.
An app is a technology company, and they know how to scale. They can build API’s (hookups) and other devices that would create simple solutions for trading.
But, Robinhood is not an asset management firm, not is it trying to be. But, if one they would, it would rock the establishment again. As a matter of disclosure, I am not an investor in Robinhood, nor do I have any financial interest in the company.
So how are all these big guys and Robinhood going to make money? It’s called order flow.
How and where your order is executed can affect the cost of your transaction and the price you pay for the stock.
Here is the skinny on order flow; basically you are allowing big institutions to see your orders and let them place fast orders before retail orders get filled. This results in many order being scalped for pennies or fraction of pennies.
A broker can attempt to fill your order in several ways:
- Order to the Floor. For stocks trading on exchanges such as the New York Stock Exchange (NYSE), the broker can direct your order to the floor of the stock exchange, or a regional exchange. In some instances, regional exchanges will pay a fee for the privilege to execute a broker’s order, known as a payment for order flow. Because your order is going through human hands, it can take some time for the floor broker to get to your order and fill it.
- Order to Third Market Maker. For stocks trading on an exchange like the NYSE, your brokerage can direct your order to what is called a third market maker. A third market maker is likely to receive the order if: A) they entice the broker with an incentive to direct the order to them, or B) the broker is not a member firm of the exchange in which the order would otherwise be directed.
- Internalization. Internalization occurs when the broker decides to fill your order from the inventory of stocks your brokerage firm owns. This can make for quick execution. This type of execution is accompanied by your broker’s firm making additional money on the spread.
- Electronic Communications Network (ECN). ECNs automatically match buy and sell orders. These systems are used particularly for limit orders because the ECN can match by price very quickly.
- Order to Market Maker. For over-the-counter markets such as the Nasdaq, your broker can direct your trade to the market maker in charge of the stock you wish to purchase or sell. This is usually timely, and some brokers make additional money by sending orders to certain market makers (payment for order flow). This means your broker may not always be sending your order to the best possible market maker.
So the bottom line is this: Stock Brokers have the ability to make a lot more money than your commissions. No free lunch still prevails.
Is “free” trading for everyone? NO!
Professional Day traders that trade frequently will prefer to trade via routes that avoid slippage, narrow ranges and other factors that would affect their executions. They will not go for this Zero commissions gimmick. This is my opinion.
What about Futures? Let’s compare apples to apples:
- When you execute a Futures contract, you cannot route it to the exchange of your choice. Each exchange has one Futures market.
- Exchange Fee – Every exchange charges for the contract it is trading. It does not matter if you are trading Futures on the CME, Eurex or ICE, there is a FEE.
- Routing Fee – The technology fee to get your order to the exchange. Some brokers combine it with clearing, and some do not. The fee is always there and it is up to the different brokers / FCM’s to decide what to call it.
But, there is one FEE that you do not pay for Futures — Leverage Fee. So let’s say you have a $10K account in stocks, and you want to get some leverage, well, most provide 50% when you trade stocks. So your total would be $15K if you started with $10K account.
Well, from the research I have done, brokers can charge you anywhere from 2.75% interest to 5% for the leverage you get.
So let’s compare apples to apples:
Let’s say you trade ONE Futures contract on ES. Let’s say it’s at the 3,000 level. With E-Mini S&P, you are trading $150,000 (3000 x 50) without paying a dime in interest. If you were to pay interest at 5% per year on that, you would pay $7,500.
OK, assume you have a 10K account, you would pay 75% of your account in interest payments. If you traded two contracts, your interest fees would be higher than your entire account. Get it?
Futures provide leverage to the small trader that does not have tens of thousands, hundreds of thousands, or millions to trade stock and options.
Futures do not have the day trading pattern rule that you MUST have $25K if you want to day trade stocks — no such rules in Futures.
The bottom line, the commissions you are paying versus the leverage you get in futures is minuscule compared to what you get trading stocks.