Who is paying your broker if commissions are zero?
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If you follow the market, you know that uptrends and downtrends come and go. But there’s one trend that’s been sinking since the 1970s: commissions. For many decades, brokers have been embroiled in a perpetual price war, beginning with discount brokers that upended the full-service brokerage model. Ever since stock trading moved online in the late 1990s, it’s been a race to the bottom for commissions. By 2019, commission-free trading became the norm among top brokerage houses.
But how do zero-commission trades work? Without commissions, how do brokerage firms make money? And for investors, what might this cost advantage “cost”?
Key Points
- Commission-free trading is now the norm for most large stock brokerages.
- Zero-commissions brokerages have other ways to generate revenue; be aware of them.
- The benefits of commission-free trading can quickly sour if you overdo it.
What are commission-free trades and how do they work?
Commission-free trading is a transaction type that allows you to buy and sell stocks, options, and exchange-traded funds (ETFs) without having to pay commissions to your broker.
Depending on your brokerage, commissions might make up only a part of overall trading fees. For example, you might be paying exchange fees, data feed fees, platform, and other technology and transaction fees collected by various providers other than your broker.
Still, removing commissions from your stock transactions amounts to money saved.
How do brokerages make money if not through commissions?
There are a few ways zero-commission brokerages can generate revenue without charging commissions:
- Payment for order flow (PFOF). Commission-free brokers typically receive payment (in the form of rebates) from market makers, who pay for the privilege of buying what you sell and selling what you buy. Market makers profit from the bid-ask spread (when you buy from a market maker, it’s at the “ask” price, and when you sell, it’s at the “bid” price). In return, the market makers compensate brokerages for routing orders to them. In other words, instead of paying a commission, you pay a small “edge” (a penny per share or less in actively traded stocks).
- Interest. Brokerages can also make money on the interest on your uninvested cash. They may pay you nominal interest on money held in your “sweep account,” but it will typically be less than the interest they can earn by investing in short-term Treasury securities or by lending to traders who trade on margin (i.e., borrowed money).
- Premium services. Many brokerages offer various premium services for a fee. Such services include premium market research (e.g., access to analyst reports), wealth and retirement services, robo-advisors, and other proprietary trading technologies and services.
So far, it sounds like “free” is a pretty good deal. It is, but there are a few risks.
The risks of zero-commission trading
Remember that 1980s movie Gremlins? They’re cute pets until you make the mistake of feeding them after midnight. Then they turn into monsters. It’s the same with commission-free trades. They’re great to have, but pay attention, treat them with respect, and follow the rules.
Don’t overtrade. Long-term investing and short-term trading are two separate disciplines. In other words, short-term trading isn’t investing sped up. Many investors, tempted by a zero-commission structure, begin to trade more frequently. They chase hot stocks, try to time the market, and fall victim to the so-called “greater fool theory.” If you have little knowledge or experience in short-term trading, it often doesn’t work out. As an investor, you might want to steer clear unless you’re dedicated to learning how to swing trade or day trade.
How’s your execution quality? Because of PFOF’s lack of public transparency, there’s a wide suspicion that commission-free brokers participating in PFOF may offer poorer execution (aka “slippage”) compared to brokerages that charge commissions. What’s the difference? It might be a penny or two per share; it might be more or less. If you’re investing for the long term—buying and selling only as needed—your transaction costs will be negligible. But if you trade every day, those costs will begin to add up, and they’ll start eating away at your profit/loss profile.
Professional traders accept slippage as a cost of doing business. Novices who think they’re pros often end up spinning their wheels.
Other fees may be lurking. Remember: Commissions may comprise only a portion of the fees you pay. So if you’re paying any other form of transaction costs, whether it’s exchange or regulator fees (more common in futures and options markets than stocks or ETFs) or any other fees, those will bite into your profits or increase your losses if you trade too frequently. Also, most brokerage platforms offer commission-free trading on online trades only. Need a human to help you execute a trade? That could cost you.
The bottom line
Any reduction in trading costs can be a plus, especially if you’re a new investor with a modest investment stash. For example, with zero commissions, you can buy a single share of stock (or even a fraction of a share) in a cost-effective way. Just be aware that the costs of excessive trading may end up outweighing the benefits of a commission-fee structure. So pace yourself, and stick with your original investment plan.
Commission-free trading: Use it, but don’t abuse it.
