I use an online broker for some of my trades, and I have tried a few brokers to see which I prefer because many of them offer a zero-fee commission on trade transactions. This is an excellent way for the average joe to get into the stock market. However, I always wondered how they generate their revenue if they do not charge commission.
Online brokers generate their revenue by making tiny amounts of money from a bid-ask spread, as well as a payment for order flow. This is where the broker takes a commission for directing orders to different parties for trade transactions. Then another way for online brokers to make money is by acting as a financial bank.
This article covers what an online broker is and the various strategies and techniques that online brokers use to make money because they offer zero-fee commission. Lastly, we take a look at the top 3 online brokerage firms and review each of them.
What is an Online Broker?
Let’s first define what a broker is. A broker is a person or firm that facilitates transactions between a buyer and a seller. An online broker is just the same thing, but everything is handled online through websites or apps on your smartphone.
Traditionally as we said, a broker makes a commission on every trade. Brokers used to charge anywhere from $7 and up to make trades, but things have changed in this day and age.
Some brokerage firms have now employed a new tactic of zero commission. How does that work? How do they make any profits on their trade? How do they recoup their lost revenue from the commissions on each trade they used to make? Here’s how.
The Bid-Ask Spread
One of the ways online brokers make money is through what’s known as the bid-ask spread. This is in fact, how many brokers make money from the majority of their trades. We first need to understand the term bid and then “the ask”. These are pretty simple concepts.
When we look at a chart or the closing price, we will see one specific price. However, when we want to make a transaction (you either want to buy or sell stock), the price you buy at and the price you sell at will be different.
Let’s look at an example; the price you see is $20.10. However, there are two prices in reality, and let’s say they are $20.08 and $20.12. These two numbers are what is known as the bid and the ask.
The price on the left will be the bid, and the price on the right will be the ask. This means that if you want to buy stock, you would have to pay $20.12 for each share, and if you have shares and wish to sell them, you would have to sell them at $20.08.
The spread would be the difference between the two prices. Now, who creates the bid-ask price. Well, the buyers and sellers set the price. Brokers have the option to request a stock price by requesting a limit order. A limit order will allow the broker to change the bid-ask price. Brokers have direct access, and thus when a limit order is put in, the stock price would then change. That, in turn, would change the price for everyone.
This is how brokers and online brokers make the majority of their income from trades. They will earn money from the spread of the bid-ask price.
Payment for Order Flow
Payment order flow is the compensation a broker receives for directing orders to different parties for trade transactions. This works in a typical scenario regarding payment for order flow; a broker gets fees from a 3rd party, and sometimes without the client’s knowledge. This naturally invites a lot of conflict of interest. The S.E.C. now requires brokers to disclose their policies surrounding this practice and publish reports that reveal their financial relationships.
Payment order flow means your trades are not happening on a public exchange but behind closed doors.
The broker usually receives tiny amounts of a share as compensation for directing a particular market maker’s order.
Interest on Cash Held in Accounts
Some brokers generate their revenue by acting as a bank. A massive portion of income can be made this way. Specifically, Charles Schwab made 57% of its revenue in 2018 by working as a bank
How this works is that the broker pays you a lower interest rate on your cash deposits with the firm and earns a higher interest rate by lending or investing the money elsewhere.
By cutting its trading fees, the broker hopes to attract more customers and hopes to have their cash idle in their accounts. Besides earning more net interest margin business off customers, online brokers are hoping to generate more margin trading and options trading business.
Let’s now look at the top 3 brokerages and how they function as an online broker.
The Top 3 Investment apps
Trading 212 is a London fintech company democratising the financial markets with free, smart, and easy to use stock market apps, enabling anyone to trade equities, currencies, commodities, and more.
They are trying to disrupt the stock brokerage industry by offering the first zero-commission stock trading service in the U.K. and Europe, unlocking the stock market for millions of people.
There is a web version of trading 212. What is great about this platform is that it is not limited to the U.S only. It offers no foreign exchange fees along with auto investing.
There are three different types of accounts that you can choose from when opening an account. You have an Invest Account, a CFD Account, and an I.S.A. account.
The invest and ISA accounts are primarily the same things except for the ISA account lets you invest your money tax-free up to the limit of £20,000 per year. The C.F.D. Account is more for the day trader. This account lets you buy and sell at the current market price.
You also have the app, which allows you to invest through the account you have chosen. This platform is slightly different from M1 finance and Robinhood and is a little more intricate and worth a look.
Robinhood is an online trading app that offers zero commission on trades. Amid the U.S financial crisis in 2013, one company launched a stock trading app in the name of the crisis called Robinhood.
Robinhood made trading easy, implementing the app on your smartphone. If you are a beginner, then this is the best app you can look into. They offer free stock when you register an account, and their user interface is easy and friendly to use.
Robinhood, besides offering stock trading, offers options trading and crypto trading in select states in the U.S.A. The only thing to note about the cryptocurrency is that Robinhood does not allow you to transfer your cryptocurrency outside the app. This means you do not have the option to store it on a hardware wallet or send it. You would have to cash out of your cryptocurrency to receive your payout.
Hence, I do not recommend Robinhood for cryptocurrency trading; however, it is a superb platform for stock ETF and options trading, especially for beginners.
Recently Robinhood announced the introduction of fractional shares. This will allow you to buy shares of stocks and ETFs in $1 increments, and this is beneficial for stock that trades at a high share price like Amazon, for example.
Another feature they are going to be adding is the cash management feature, which will be a high yield savings account. This will give you an excellent option for your uninvested cash. This could be used to get a return for the money you do not want to use in the stock market. At this point in time, they are quoting that at a 1.80% APY; however, that will change based on the federal funds rate.
When people think of online trading platforms that offer zero commission, they think of Robinhood because they pioneered the commission-free stock broker’s industry.
M1 Finance was first to come out with fractional shares, which Robinhood now offers. As we stated, you can purchase fractional shares instead of 1 entire share that will cost a ton of cash.
M1 finance offers you a pie-based investing model, which means a visual pie chart represents your portfolio. If you are not interested in building your own portfolio from scratch, the app offers you Expert Pies. This section of the app lets you invest in portfolios that have been drawn up by professionals. Some include responsible investing, hedge funds, stocks and bonds, industries, and sectors. They have almost 100 portfolios from which to choose.
They also offer a dividend reinvestment plan. Let’s say you own preferred stock in Apple. They pay out a quarterly dividend to their shareholders of a certain amount. Now, you can take that money and put it in a savings account, spend it, or you can reinvest it. If you had to take that dividend and reinvest it into the same stock, you would effectively increase your shares and gain compound interest. This is called a stock level drip or dividend reinvestment plan.
M1 offers a portfolio reinvestment plan, and that means that any dividend return you get will be reinvested across your entire portfolio.
It also features an automated deposit, so if you wanted to add a certain amount of cash every week or month into your M1 Finance account, you could easily do that.
Robinhood broke the market with its zero-fee commission back in 2013, and it changed the way people could invest in the stock market, giving the power to the public. These platforms make their money through other methods, and the majority of their revenue comes from bid-ask spread trading, payment for order flow, and acting as a financial bank.
If you are a beginner, then these three platforms are a great way to get into the stock market with portfolios that are already set up for you to invest in, or you can even create portfolios from scratch investing in stocks, ETFs and options. It’s all up to you.
Or… If you want to go the completely opposite direction, you can bypass the broker and invest directly with companies.
You get what you pay for, even though these accounts are free, you might be better off paying a small commission to someone like eToro, and gain better customer service under a more advance platform.