Is Commission Free Trading Really Free?

Every Tuesday Chuck releases a new Trader Tip video on YouTube. I like to say there's no free lunch. So commission free trading is not really free. This week we will discuss what that means. Watch the Trader Tip Episode for more information! 

You can read the episode transcript below or watch the video that follows.
If you have any questions, please reach out to us. We look forward to being a continued part of your trading education!


This is the big lure now for customers is the idea that you can trade commission free, pay no commissions at all. The question I have for you though, is that if you really get to trade for free, well, then how do brokerages make money?

I mean, after all, if they let you trade for free, there's got to be something that they're doing. Wouldn't it be interesting, wouldn't it be important to know what those brokerages are actually doing?

What I want you to understand is that banks and prop trading firms pay brokerages for the rights to make markets for their clients. This adds up to hundreds of millions of dollars a year for the brokerage and it's really risk free money.

We do a lot of our trading in Interactive Brokers. Interactive Brokers is the only brokerage I know of that does not engage in payment for order flow.

Now I put a link here that you can click on it really gives some great insights as to how this works. But I'm going to describe even further.

This is from 2020. This is the amount of revenue that was generated per quarter for each of the major brokerages from payment from order flow. You can see TD Ameritrade was making 119 million, 117 million, 128 million, 135 million. Okay, that was basically 500 million in a year, and payment for order flow. That's where all the revenue comes from, and then look at 2020 It was already greater than that, it was 560 million just in the first two quarters. Now we have E trade and we have Schwab and then there was Robinhood, which became the rage, and you can see Robinhood came out of nowhere to doing 180 million in revenue just in the second quarter.

Why would prop firms and banks pay that much money to brokerages?

Well, I put an excerpt here from flash boys, which really describes this pretty well you can read through this. You can see that TD Ameritrade was, as they said they were making 500 million a year in 2019, and probably close to a billion dollars in 2020.

What I want you to understand I'll get into this even further in another Trader Tip Tuesday, but what's happening is high frequency trading firms and banks get the rights to make two sided markets to the customer. The idea is is that when you're trading with customers at TD Ameritrade or Schwab, or E trade or Robinhood, that in general, these are clients that really don't know what they're doing. These are clients that we talk about a Trader Tip Tuesday and we talk about in the daily Facebook's these are the clients that we always are railing against the people who are psychologically flawed, who trade highly emotional, they trade on fear and greed. They have no clue what they're doing. They have no money management, they have no plan, they have no discipline. They suck. And you know what? This is the perfect customer to trade against when you're a prop firm.

Because you don't get run over. It's clean. They don't know what they're doing. They'll pay the offer. They'll sell the bid. They'll do it over and over again, and it's clean, easy money.

For you if you're not aware of this when you are trading at these different brokerages, you think you're getting a deal because you're getting commission free trading, but the reality is, is that you are getting screwed. You're getting screwed because you are trading at the bid offer of the brokerage.

Now, there's this thing called NBBO National Best Bid Offer and the brokers will say to you "no no no you get the best price that is out there." By the NBBO that is sec law, but that's actually bullshit. Because the NBBO is a slow system, and what happens is high frequency firms can get to your order faster than your brokerage can get you to it. So they know what's going on, and when they see your order, they effectively are racing you from point to point cleaning out the orders that could be yours. And then they trade with you with no issue. They're running all these little arbitrages, and they're running these nice wide bid ask spreads that they get paid again and again and again and again and again.

If they're paying TD Ameritrade $500 million in a year in order flow, you know that they are making billions. They don't pay 500 million to make 100 million. They're making at least a billion dollars, at least.

That's why I love trading Interactive Brokers. Yeah, you pay commissions. Great, you should want to pay commissions because you want to get the best bid ask spread possible. I show this in our classes all the time, we talk about the mechanics of position management and options trading, we go through this all the time and understanding this literally can save you 1000s and 1000s and 1000s of dollars a year. If you trade any kind of volume can easily save you anywhere from 15 to $50,000 a year. That's because you get better price discovery.

I like to say there's no free lunch. So commission free trading is not really free. Hopefully this is helpful. We'll talk more about this in a future Trader Tip Tuesday, and stay tuned every Tuesdays for lessons like today, where we teach you different ways to think about trading to help take your performance to an elite level. Have a great week. God bless. I'll see you next week.