How Free Stock Trades Can Be Expensive

Behavioral economist Dan Ariely demonstrated the impact of “free” in an experiment that he described in Predictably Irrational.

At first, participants could choose a Hershey’s Kiss for a penny or a Lindt Truffle for 15 cents. Selected by 73%, the (tastier) Lindt chocolate was much more popular. Next, he brought the price of each down by a penny. That meant the Hershey Kiss was FREE and the Lindt went for 14 cents. Then, 69% chose the Kiss and the Lindt’s popularity plunged. We can hypothesize that FREE had a massive impact on demand. Finally, to be sure, in a third approach, he priced the Hershey at 2 cents, the Lindt at 27 cents, and again decreased the price by a penny. This time, paying a penny less made little difference. We should point out though that free did have a cost. The chocolate eaters sacrificed the tastier tidbit for the Hershey Kiss.

Where are we going? From free Kisses to free stock trades…and what they really cost.

Commission Free Stock Trades

In 1983, buying a security from a (human) stock broker could have cost $200 while a 1990s online order might have had a $40 price tag. Before 1975, that fee was fixed. After, when regulators said firms should decide, some brokerage companies raised prices while others lowered them. Competing, all had to decide how they would make money.

In 2013, a firm called Robinhood decided FREE was the answer.  Implementing commission free stock trades, they made their money through “payment for order flow.” When Robinhood’s CEO recently presented testimony to the House Committee on Financial Services, its payment for order flow was the focus.

This is how a payment for order flow can work:

• Paying nothing for the transaction, a Robinhood customer enters a sell order at a current stock price.
• Within several hundredths of a second, the order is routed to a high frequency trading firm.
• That firm buys the shares.
• Money is credited to the seller’s account.
• Meanwhile, Robinhood is paid for sending the shares to the high frequency firm.
• And, the high frequency trader can make its money through the “spread.” Defined as the difference between its buy and sell price, the spread can be a fraction of a penny. But, through many millions of transactions, high speed traders can generate huge earnings.

As a source of the volume the high frequency traders need, Robinhood made close to $700 million last year. The practice has been called controversial because Robinhood’s customers are paying for their commission free activity through Robinhood’s financial relationships with third parties. It is possible, for example, that a customer might not get the best price for a trade.

Below, stock traders can pay zero commissions for a buy or sell order because their broker, Robinhood, gets its payments from a third party:

Our Bottom Line TANSTAAFL

Zero commission trading reminds us of TANSTAAFL Whether you are eating chocolates or trading stock, There Ain’t No Such Thing As A Free Lunch.

My sources and more: For a good listen, I recommend The Journal podcast. Last week, they explained “How Robinhood Makes Money.” Then this history of zero commission helped to complete the picture.