Online broker Robinhood took the world by storm in 2013, when it promised to “democratize finance for all,” in part by offering zero-commission stock, ETF and options trading.
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Soon, copycat brokers were popping up online, and now even major firms like Merrill Lynch and Chase offer customers zero-commission trading. But are customers really getting a good deal using these so-called “no-cost” brokers, or are there hidden fees involved that can make trading on these platforms actually more expensive? Here’s what to look out for when using online brokers.
The True Costs of Trading
It’s true that no-commission brokers like Robinhood don’t charge a commission for stock, ETF and options trades. However, commission is just one part of a company’s fee structure — and the amount that investors actually end up paying can vary dramatically from broker to broker, and even from trade to trade.
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Spread
In addition to commissions — which are zero for brokers like Robinhood — there are other fees that can add up significantly. One of the most expensive is the “spread,” which is the difference in price between what a buyer has to pay and what a seller gets. For example, to buy an IBM Nov 100 call, an investor might have to pay $5, but a seller will only get $4.80. That $0.20 difference is the spread.
A recent study by SSRN analyzed just how much investors were paying on options trades at Robinhood and other brokers, including the spread, and the results are quite surprising — although it must be noted that Robinhood disputes the findings, the Wall Street Journal reported.
Specifically, as reported by the Journal, three finance professors made nearly 7,000 options trades at six different brokerage platforms from May to June — Robinhood, Fidelity, Vanguard, Charles Schwab, E*Trade and TD Ameritrade.
According to their data, the average round-trip cost — or the cost to both buy and sell an option — was a whopping 6.8% at Robinhood. This means that for every $100 traded, $6.80 was lost to expenses. At the other end of the spectrum, Vanguard had a roundtrip transaction cost of negative 0.3%, meaning the firm was offering customers much better execution prices.
How Could There Be Such a Discrepancy?
Robinhood accepts payment for order flow, meaning it gets paid to direct trades to certain firms for execution. Although the firm says that this doesn’t affect the prices that customers receive, the data from the study shows otherwise.
According to the data, traders at Robinhood tend to get filled at the extremes of the bid-ask spread, whereas those trading at Vanguard and other firms benefit from executions closer to the middle of the spread, resulting in lower costs.
Is That the Whole Story?
No analysis can rely on a single data point. Although Robinhood options customers appear to receive worse execution prices, the firm also doesn’t charge anything at all in terms of commissions or fees to customers. Vanguard, on the other hand, charges a $1 fee for each options contract traded, while Schwab, Fidelity, E*Trade and TD Ameritrade charge 65 cents.
As a result, the authors of the study found that Robinhood was actually the cheapest place to trade for options with a spread of 1 cent. However, for options with wider spreads, which is the bulk of existing options according to the authors, Fidelity or Vanguard are better choices.
Does This Mean Investors Should Avoid Zero-Commission Platforms?
The results of one trading example shouldn’t discourage investors from trading at Robinhood, or other zero-commission platforms, if it is their preferred investment firm — especially when the company challenges the accuracy of the report. But it’s an excellent lesson in how investors should dig deeper beneath headline fees and charges to determine exactly how much they are paying to buy or sell an investment.
While Robinhood and other firms tout “zero-commission trading,” it doesn’t come without a cost — just like “no-load” mutual funds still quietly deduct annual fees from investor capital. To make the best financial decisions, take the time to learn if an investment’s hidden costs outweigh the benefit of its low fees.
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This article originally appeared on GOBankingRates.com: Why Zero-Commission Investment Platforms May Not Really Be Free
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