Episode #21 - How does Robinhood make money?
The age old question: What's the catch?
Intro:
Trying a shorter note today to see if this yields more reviews. I don’t right the notes for the sake of a review, but a review does give me feedback if the note is hitting the spot. Your lack of clicking “unsubscribe” has a similar impact, but reading to the end and leaving a brief review in the new “review” form helps me improve the notes, get more topics you want to learn about, and see if my theory around interactive investment community has some legs.
For today I want to take a stab at a nuanced take regarding the now famous Robinhood trading app. They burst on the scene in the early 2010s as a way to trade stocks for free. As any person who reads a note about investing on Monday mornings, you’re likely at least a little bit of a skeptic. Free trades? It must be too good to be true. Join for a brief exploration to understand how it works.
Background:
First of all you must understand that the move to totally “free” trading didn’t emerge in a vacuum. Long before free in the form of Robinhood there was heavily discounted trades brought into the world by E*TRADE.com (the ad agency my mom worked for actually invented the “e-trade baby”) and other groups like it. At the time, low was in the range of $8/trade, compare that to people who would pay $25/trade PLUS commission to the broker.
In 2013 Robinhood changed the retail investing game by announcing that when you got on to their platform you would not pay to trade stocks. Understandably, the race to $0/trade quickly bloomed and now even E*Trade offers most trading for free.
The question remains: if they don’t charge for trades, how do they make money?
The Meat and Potatoes:
Robinhood makes money two ways (their website covers some more here, but I’ll offer some commentary):
They offer a premium product called Robinhood Gold which costs $5/month.
Why would anyone pay for that? Simply you get to trade an extra $1000 that you don’t have in your account when buying stocks on margin - a topic worthy of another essay. There are other benefits to Robinhood Gold, but like any subscription you need to decide that what you get from an extra $5/month out of your pocket is worth it. If you’re jumping in the deep-end of trading, having some extra money to play with could be worth it - though act with an abundance of caution.
Payment for order flow emerges as the way Robinhood makes money from people who are not Gold members (they get the money from Gold members too).
What in the world is that? Great question. Here is an illustration from the Wall Street Journal:
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.
The question then becomes do you, the trader on Robinhood, get the benefit of the lower price when you trade with Robinhood compared to a place like Schwab or TD Ameritrade in the above example. According to most, you do not.
This means that you likely get a slightly WORSE price on Robinhood for your trades even though you don’t PAY for an actual trade.
There are a couple other ways that they make money, but this is what I’ll leave you with this morning.
Takeaway:
Understanding how brokerages writ large make money should be something you know about. All brokers are doing something like what Robinhood does, though Robinhood seems to be a bit more cards to the chest in what they share with investors. When you make large transactions you are most likely to suffer from getting worse prices on your trades.
Interact:
Do you trade at all with Robinhood?
You might guess that I don’t think Robinhood trading is the way to generate wealth, but I do think that it would be a good practice if it gets you to follow what’s happening in the market more closely. Comment below, or respond to this note if you have a stock or type of business that you want to follow more closely and I’ll find some stocks for you to follow that would relate to those markets.
Gratitude:
Thanks to all of you for reading this week - your feedback means a lot and helps me improve these notes!
Have a great week.