How Robinhood Really Makes Money, and Why It No Longer Matters

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While it seems that Robinhood and Gamestop are officially the new gambling version of a multiplayer online video game (CNBC, BI, Bloomberg), this story reminded me of this past Matt Levine article which is my favorite detailed-yet-understandable explanation of how Robinhood makes money. There have been many similar attempts to explain their business model, but this felt the most balanced. Even the footnotes are educational.

For example, he explains how the biggest brokers like TD Ameritrade used to handle payment for order flow, which you could equate to a discount on the stock price (“price improvement”):

“We’ll buy stock for you, you’ll pay us $5 to do it, we’ll get a discount on the stock and we’ll pass on 80% of the discount to you.”

Compare this with how Robinhood chose to do handle payment for order flow:

“We’ll buy stock for you, you won’t pay us to do it, we’ll get a discount on the stock and we’ll pass on 20% of the discount to you.”

Robinhood also happens to get paid more for their order flow than other brokerage firms. I’ve also explored this question back in 2018: Does Robinhood Brokerage Make Money in Shady or Questionable Ways? My basic conclusions were that:

  • Robinhood would be breaking the law if they broke the SEC rule of National Best Bid and Offer (NBBO) that requires brokers provide the best available bid and ask prices when buying and selling securities for customers. They wouldn’t do that, would they?
  • The order flow from Robinhood is probably more valuable because it is from small, retail investors (“dumb money”).

Well, it turns out that:

If you don’t read Matt Levine’s entire explanation, here is the bottom line: Robinhood customers were essentially being charged an extra roughly 3 to 5 cents a share through poorer execution prices. If you only traded a few shares, then you still basically paid nothing. If you traded 100 shares, that might add up to $3 to $5 total. Roughly breakeven. If you traded 1,000 shares, that might add up to $30 to $50 total. For some people, Robinhood’s “free trades” were a better deal. For others, Robinhood’s “free trades” were a much worse deal.

Supposedly, Robinhood doesn’t do this anymore and satisfies NBBO again. But it still shows the general way in which Robinhood makes money today. High-frequency trading firms pay somewhat higher prices for the trading flows from Robinhood users, and Robinhood keeps as much of that money as possible while still barely satisfying NBBO. Perhaps a smaller number on the order of a half-penny a share. Other firms like Fidelity proudly boast of how they do better than NBBO (“price improvement” again), which is also a quiet dig at Robinhood.

[Fidelity’s] price improvement can save investors $18.53 on average for a 1,000-share equity order, compared to the industry average of $4.25.

All this no longer matters because Robinhood is no longer the sweet spot for newbie traders. People like to make fun of the Robinhood name because in a way they secretly stole from the “poor” average traders and sold their orders to the “rich”. However, they also forced everyone from Fidelity to Schwab to all offer commission-free trades. Robinhood did deliver something to us common folk!

The important difference is that firms like Fidelity and Schwab still have wealthy clients that demand phone numbers with helpful humans that answer after only a few rings. Meanwhile, Robinhood only provides an overwhelmed e-mail address than can take days or weeks to finally address your problems.

When Robinhood first came on the scene, they were the new sweet spot for cheap trades for small balances. However, now that free trades are everywhere, the sweet spot in my opinion has now shifted to something like a Fidelity or Schwab account. You get total commission costs either equal to or lower than Robinhood, plus better customer service from more knowledgable reps. If you still prefer a trendy new app over a stuffy old broker, check out my Big List of Free Stocks For New Commission-Free Brokerage Apps. Most of them have a phone number, and they’ll be less busy. (WeBull, M1 Finance, and Firstrade for sure have phone numbers.)

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Comments

  1. I assume you really meant the cost to you would be per order, not per share…

    • If you mean the price improvement that Robinhood kept for themselves, that is on a per-share basis. I base the values on this SEC quote, as $5 divided by 100 shares is 5 cents a share:

      For most orders of more than 100 shares, the analysis concluded that Robinhood customers would be better off trading at another broker-dealer because the additional price improvement that such orders would receive at other broker-dealers would likely exceed the approximately $5 per-order commission costs that those broker-dealers were then charging. The analysis further determined that the larger the order, the more significant the price improvement losses for Robinhood customers—for orders over 500 shares, the average Robinhood customer order lost over $15 in price improvement compared to Robinhood’s competitors, with that comparative loss rising to more than $23 per order for orders over 2,000 shares.

      • Adding to Michael’s comment, you say in the article: “If you traded 100 shares, that might add up to $3 to $5 a share. Roughly breakeven. If you traded 1,000 shares, that might add up to $30 to $50 a share.” We’re saying that should be per “order”, not per “share”.

  2. I don’t think this is very important. Rule #1 when it comes to trading stocks is to use limit orders. Who uses market orders anyway? This doesn’t apply to 99.99% of people. Or am I missing something? What I am saying is that I put a limit order and wait for it to get filled at a specific price. And I am not paying a cent more. So, how does this hurt me?

    • Execution quality still apples to limit orders. If you make a limit buy order for $10, you might get it filled at $9.99 at one broker and $9.97 at another broker. One broker still costs you more money than the other. You might get your buy order filled at $10 at one broker and not at all at the other broker. Just making a limit order doesn’t mean you’ll eventually get that price.

      The benefit of limit order is mainly that you won’t have some unlikely-but-possible bad fill. If you make a limit buy order for $10, you won’t be exposed to buying it at $11. If you make a limit sell order for $10, you won’t be exposed to selling it for only $9.

      • This is the first time I have to disagree with you. I have never used limit orders the way you are describing. I use limit orders when I want to buy a stock below current price. You place your order and when the price comes down to the price you want to buy at it gets filled. It’s that simple. You don’t pay a penny more or a penny less, you pay exactly what you want to pay. What you are describing is essentially a market order with a collar. The stock is trading below $10. You watch the ticker tape and it is 9.97, 9.96, 9.97, 9.98. When you are putting you limit order with a $10 limit, you are basically saying you are willing to buy at whatever the current market price is but pay no more than $10. You hit the buy button and your order is executed that very second at whatever the current market price is. And you are right it can be 9.95 or 9.96 or 9.97, etc. Just no more than 10. So, like I said, you are essentially doing a market order and yes, for you, the execution would matter. And since there are several exchanges, like NYSE, NASDAQ, ARCA, BATS, etc., the price can be different by a penny or two. And it is important where Robinhood routes your order.

        • In your example, yes let’s say you put in a limit order saying you won’t pay more than $10. If Robinhood fills your limit order at $10 and Fidelity at $9.97, then on a 1,000 share order, Robinhood will have cost you $30 more than Fidelity. That’s real money you’d be missing, even with a limit order. Limit orders don’t always fill exactly at their limit price, I get price improvement all the time on my limit orders that is better than the actual limit value.

          —-

          Here’s a different analogy to help clarify my previous comment:

          Supermarket #1: We always mark up strawberries at $1 a pound above cost.
          Supermarket #2: We always mark up strawberries at $2 a pound above cost.

          Limit order: I will never buy strawberries at more than $3 a pound! Not a penny more!

          Would you rather shop at Supermarket #1 or Supermarket #2? Do you think it still matters? I do, even if you chose an arbitrary price point. Limit orders don’t negate the importance of getting good market execution. For any arbitrary price point, even if you are on that edge, some orders will get filled at Supermarket #1 and not Supermarket #2. If you are not on that edge, then the top example holds.

  3. Ditto…use limit orders only…if you get your price, what’s the problem?

    • That logic doesn’t really hold, as why not just lower your limit price then? If you think a $10 per share limit buy order for 100 shares is the same at every broker, then why not change it to a $9.95 limit buy order and save yourself $5? Just wait until you get your price, not a penny less, right? Or change it to a $9.90 limit order, and so on? The order might fill at one broker, and not the other. I use limit orders too, but that doesn’t change that trade execution quality matters.

    • When you put limit order you usually get price improvement. stock trading at 16 you put order with limit of 16.10 fidelity fills it with 16.05.. Robin hood also does it but looks like from above article not so much.

      Robinhood and such are still sweet spot for option trading. .65 cents per contract per order makes for smaller option trades with premium being in few pennies starts you trade in red. so 5 contracts in single order with 2 legs would cot $6.5 to buy and and $6.5 to sell. Webull robin hood do not charge these fees. price improvement alone can no help in such scenarios where premium is say $5 per contract..

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