A few years back, Robinhood made a big splash in the retail trading world by offering Commission-Free options trading.
Retail traders and the media that served them rejoiced!
"This is a game-changer!" they shouted.
And in some ways it was. But not in the way you might think.
It changed the game for retail options brokers to be able to attract multitudes more sheep to get shorn. How?
For one thing, retail brokers are able to command top dollar from market-making firms who pay the brokers for the opportunity to take the other side of retail trades. This is called Payment for Order Flow (PFOF).
In the first half of 2024, Robinhood earned substantial revenue from payment for order flow (PFOF), particularly from options trading.
In Q1 2024, options trading contributed $154 million to Robinhood’s transaction-based revenue, a 16% increase compared to the same period in 2023. This represented a significant portion of the $329 million total transaction-based revenue for the quarter. Although the Q2 data continues this trend, Robinhood’s total revenue from transaction-based activities reached around $327 million in Q2 2024, with options trading still being a major contributor.
That's a lot of revenue from a service they advertise as "commission-free."
Options trading typically contributes the largest share of Robinhood’s PFOF income compared to equities and cryptocurrency.
Ok, so how are Robinhood and other retail brokers able to offer "free" or cheap commission options trading?
Because options market makers look at retail trading flow as the "dumb money."
The dumb money pays the ask to buy, and hits the bid to sell. And they cannot update their buy or sell orders in the same nanoseconds in which the market makers can move their quotes to account for changes in supply/demand inputs.
In other words, there is chum in these waters and hyper-fast sharks (market makers) know how to pluck all this order flow to their advantage.
Now, I'm not sitting here and declaring any of this bad, immoral, or illegal. This is the way the industry works and it is the cost of doing business.
But anytime you see "free commissions" being advertised, it should be plainly clear to you that nothing is free, and your true costs are simply hidden.
6%+ of buy/sell price as true cost of trading options on Robinhood? That doesn't market as well as "free commissions."
The article mentions: "Retail brokerages often try to fill customers’ orders at prices within the bid-ask spread. Getting orders filled in the middle of the spread benefits investors because it means they save money on purchases, or earn more money on sales. The study found that Robinhood was more likely than other brokers to fill orders near the extreme ends of the bid-ask spread."
Now to be fair: "When factoring in fees, Robinhood is the cheapest broker for options with a bid-ask spread of 1 cent, the authors found. But for options with wider spreads—the majority of options contracts in the marketplace—Fidelity or Vanguard are the best."
I'm not intending to pick on Robinhood specifically here. In fact, I have a small Robinhood account that we opened for my son. We buy and hold small stock positions via their app and I love the ease of use. It truly is an excellent, and easy-to-use app.
But you won't find me trading options on it.
And while Robinhood might be the most extreme example of hidden transaction costs, it is not alone. Nearly every broker, to varying degrees, participates in these same schemes to make money.
There's no free lunch on Wall Street. Never was, never will be.
When choosing an options broker, don't just fall for the headline commission rate. You also need to consider how their unique fee structures interact with your style and frequency of trading. How well can you operate their trading platform? Do you get the type of reporting you need to manage your account properly? Do you earn interest on your cash balances, and if so, how much? How likely are you able to find and get the help you need when you run into a platform or trading snag? These are just a few of the questions you need to ask yourself and of your broker.
All of these things matter. And no one thing will be of the same importance to one person than another. We all have different requirements and needs.
But please, don't fall for the cheap commission trap. Be sure you're factoring the hidden costs as best you can and the benefits the trading platform offers you in exchange.
Sean McLaughlin | Chief Options Strategist, All Star Charts
