How You Can Avoid Being Ripped Off by Free Online Brokers
Commission-free trades aren’t what they seem.
In reality, they’re a way for brokers to accept legal bribes. Bribes so large that they can offer you free trading, no sweat.
If it sounds dirty, it’s because it is dirty. There’s a side to the brokerage business that’s as corrupt as they come.
The online brokerage business is now dominated by legal bribes called payment for order flow, or PFOF.
Here’s how it works:
- You send your order to the broker.
- The broker gives a market-making firm a first look at it.
- If the market-making firm wants it, they trade it and then print it on an exchange.
- If they don’t want it, they take the order and place it on an exchange until they (or someone else) decides to fill it. (This usually happens on Limit orders away from the market.)
- The exchange they put it on pays the firm a “maker/taker” fee to place the order there.
- The person who executes the trade actually has to pay to fill it.
- When the order trades, the market-making firm collects $0.25 per 100 shares.
- The trader that actually executed the trade pays $0.35 per 100 shares.
Let’s say you’re trying to sell a stock at $15. In reality, your actual offer is $15.0035.
That doesn’t look like a big difference. But in the stock and options business, it’s huge. $0.0035 is more than a firm is making on average per stock trade, and it’s about on par with the profit and loss of each option trade a market-making firm executes.
The price you’re seeing, as the seller, is actually the worst price. You’re looking at $15 – but the buyer has to pay the “take fee” of $0.0035. Then, when your sale finally trades, the stock immediately goes to $15.01 or $15.05 – because your offer wasn’t $15. It was $15.0035. So even if the stock trades at $15, you don’t get filled. Not until it hits your actual offer.
And either way, you just lost money. And that’s the standard practice of payment for order flow.
Brokers will promise you “best execution.” But what is the best execution on a market order?
Take a look…
Stock X has a bid of $25.05 and an offer of $25.20. That means your fill could be anywhere between those two numbers. That sounds wide, but you would be surprised by how many stocks outside of the 100 most active have $0.10-$0.25-wide markets.
If you send a market order to buy stock X and the market maker fills it at $25.19, that’s still technically best execution – even though a $25.05 price was available.
From my own years of market making, I am 100% certain that on a $0.15-wide market in just about any stock, it would fill at least $0.05 better than the offer – if not closer to the mid-price.
So how can this be classified as best execution? Well, simple.
Because the brokers wrote the rules.
Your “free” order isn’t free. It actually costs you much more than what you were paying in commissions before. And you might think, “hey, I don’t trade that much, it’s worth the free commissions.” But think about this. If you do $0.05 worse on 1,000 shares of stock per week, you’re technically paying $2,600 a year for your “free” commissions.
Go ahead, check your old brokerage statement. I can guarantee you didn’t pay that much before.
So what do you do?
- Never use market orders.
When you place an order to buy a stock at market, you aren’t setting a specific price. That means the stock could move in the time you place the order and the time the order is filled, giving you a bad price. And market makers love to drop the price of the bid before filling the stock, especially on illiquid names.
Instead, always use limit orders. This is an order to buy or sell at a specified price. Even if you want the order right away, this is the best way to ensure you’re getting in at exactly the price you want.
That way, market makers can’t “move the market” on you as much as they might want.
- Learn to “work” an order.
You should never trade in a hurry. If you’re putting your money on the line, then make sure you have the time to do it. That way, you can really learn how to work your order.
For starters, I wouldn’t use a “smart router.” This is what your broker uses to send your order to the market. But it’s only smart for the broker, not the buyer – because it helps them collect the most fees.
The smart router allegedly optimizes the route your order takes to get you the best fill. But in reality, they optimize your order to the broker’s benefit so that they can maximize their PFOF payment.
Instead, route your order to the NYSE or the NASDAQ. Not all brokers allow you to do this – but if they do, there will be a drop-down menu that allows you to select “best” instead of “smart” when choosing your route or exchange.
This way, your order essentially hits the “open market,” and you have more traders looking at your stock or option trade – not just one market maker getting the first free look and routing you to a “maker/taker exchange.”
- Walk your order up.
If you want to buy a stock with a wide spread – like our stock X example – then start by putting your bid below the mid-price. Say the spread is $25.05-$25.20. You’ll want your initial bid to be something like $25.10 – that’s your limit price.
If it doesn’t fill after a few seconds, then you need to start “walking it up.”
You can move your bid to $25.12, then to $25.14, then to $25.16. If the market doesn’t move drastically, you will most likely get filled using this technique.
If not, you can pay the offer. But even if you do that, you will probably see price improvement. Traders want that wide offer, and they – just like the market maker – will improve the price.
Wall Street’s business likes your money and your orders. But it doesn’t like you. All Wall Street wants to do is remove the dollar bills from your pocket. But if you follow these three steps, you have a chance to move that cash the other way.
Your only option,
April 19 2021