How Robinhood is profiting from the options boom
This practice, known as payment for order flow, has made options a cash cow for brokerage houses such as Robinhood Markets Inc. and TD Ameritrade. They can earn twice or more by selling customer option orders than by selling the stock order flow.
In the 12 months to June, the top 11 U.S. brokerage firms raised $ 2.2 billion for selling client option orders, according to Larry Tabb, head of market structure research. market at Bloomberg Intelligence. This was about 60% higher than their take to sell stock orders.
During that time, major brokers were paid an average of around 16 cents for every 100 shares of their clients’ stock purchase orders, compared to around 54 cents for option orders of the same size, the data shows. by Mr. Tabb.
While the payments are legal and have been around for decades, they have come under renewed scrutiny following the January trading frenzy over GameStop Corp. shares. The Securities and Exchange Commission is reviewing payment for the flow of orders, and its chairman, Gary Gensler, said the agency is open to the practice being banned.
Critics say order flow payment has reshaped the business models of brokers to make them more leveraging clients’ trading activity, sometimes through game-like smartphone apps. Some warn that larger order flow payments from options activity can actually push inexperienced clients into risky trades they don’t understand, exposing them to large potential losses.
âThere are conflicts of interest here,â said Paul Rowady, research director for Alphacution Research Conservatory, a market research and consulting firm. “They’re going to push you towards the Lamborghini, not the Bronco.”
Brokers like Robinhood claim that the practice has broadened access to investing by allowing them to reduce commissions to zero. âPayment for order flow, coupled with technology, has helped make investing less expensive and more accessible for millions of investors from all walks of life,â said Dan Gallagher, Robinhood General Counsel.
A spokeswoman for TD Ameritrade said the company “does not encourage clients to trade options” and investors tend to become interested in options as they gain experience.
Options confer the right to buy or sell shares at a specified price on a specified date. They can be used for hedging or speculating. More than 38 million options contracts changed hands on average every day in 2021, up 31% from last year and the highest level on record.
Robinhood announced last week that he made $ 164 million selling options orders in the third quarter, more than triple what he earned from such payments linked to stock transactions. The company said about 13% of its clients trade options, which means the higher options income comes from a smaller slice of Robinhood’s user base.
Option payments represented 45% of Robinhood’s total net revenue in the third quarter, while the other two types of order flow payments the company receives – for cryptocurrencies and stocks – accounted for each about 14% each.
The primary sources of payment for order flow are e-commerce companies such as Citadel Securities and Susquehanna International Group LLP. These companies make more consistent profits when trading with individuals than with other large, sophisticated traders. To gain more business from small investors, companies pay brokerage houses for the flow of orders.
Brokers are paid more for options than stocks because the potential profits are greater for companies that execute investor option orders, traders and exchange executives say.
Here’s why. Companies such as Citadel Securities and Susquehanna are market makers. This means that they trade stocks or options throughout the day and collect the difference between the buy and sell price. These âbid-ask spreadsâ are generally wider in options than in stocks. For example, the average spread for Apple stocks was around 1 cent in September, while the average spread for Apple options was around 14 cents, according to data provider MayStreet.
The difference is in part due to the fact that there are over 2,000 types of Apple options, according to data from Cboe Global Markets Inc., with many strike prices, price levels at which investors can exercise their right to buy or sell. With the large number of contracts, there are fewer price quotes in many of them, resulting in wider spreads between offers and demands. Wider spreads mean greater profit opportunities for intermediaries such as market makers and brokerage houses.
Compared to stocks, “it’s a very different market structure,” said Joanna Fields, founder of consulting firm Aplomb Strategies. “There is very little liquidity with every strike.”
Some traders say that the convoluted structure of options markets further encourages payment for order flow. SEC rules require that investor orders be executed on one of the 16 U.S. option exchanges. Exchanges typically pay discounts to market makers who route orders from individual investors to their markets. These discounts inflate the payments that go to brokers.
In theory, market makers compete with each other on the options exchanges to execute each order at the best price. But that’s not what happens in practice, said Michael Golding, head of trading at Optiver US LLC, a market making company. Instead, companies that engage in order flow payment often route investors’ orders to exchanges where they are likely to execute the orders themselves, according to Golding. A complex system of foreign exchange fees discourages other companies from competing to fill these orders, ultimately hurting investors, who might not get the best possible price, he added.
âThis is what the SEC really needs to look at,â Mr. Golding said. “Who in this whole scheme is dealing with the investor?” “
Individuals have crammed into options since brokers cut fees for options trading at the end of 2019. The influx has gathered momentum with the Covid-19 pandemic and the craze for options. same actions of this year. Retail traders accounted for about a quarter of all options activity in June, up from around 21% in January 2020, Alphacution estimates.
In its October report on the GameStop Frenzy, the SEC suggested that payment for order flow encourages brokers to design digital âgamelikeâ applications that cause their clients to trade too many.
Brokers have long made money from transactions by charging commissions. But new businesses like Robinhood are less reliant on traditional sources of income, such as collecting interest on cash balances, which are not volume driven.
Unlike brokers, investors do not necessarily benefit from frequent options trading. Research has shown that people who trade options tend to have lower returns than those who stick with stocks.
Robinhood has already come under scrutiny for certain options-related practices. Under rules designed to protect new investors, brokers must verify the age, income and investment experience of clients before letting them trade options.
In June, the Financial Industry Regulatory Authority discovered that Robinhood had approved thousands of unqualified clients for options trading after going through the company’s automated approval process. Robinhood paid $ 70 million to settle this and other Finra allegations, without admitting to wrongdoing.
Robinhood claims to have made its approval process more rigorous. The TD Ameritrade spokesperson said, âOptions carry unique risks and are not intended for everyone, which is why not all retail clients are permitted to trade in options.
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