Robinhood Leading Charge to Democratize Stock Market

Robinhood App

Participation in the stock market used to be limited to investors of real means. Technology has changed all that, and things just got a whole lot more accessible lately.

Technology has dramatically changed the way we live, and among the many changes that this has brought, greater and more efficient access to stocks is right up there with anything. This revolution has actually been going on for a very long time, but things have really accelerated lately as we have now leveraged our technologies to completely open things up.

Processing stock transactions used to be a very labor-intensive task, where at one time they only actors were humans and their only tools were pen and paper and a telephone. All that labor not only made trading stocks very expensive, it kept most people out of the game, people left out because they could not be served efficiently enough.

The hiring of computers to help us with these things changed everything, although this change has been far from gradual. The transition could have been made even faster, but old ideas die hard, and die even harder in the world of investing where old ways tend to be clung to well past their prime, where change becomes resisted at every turn it seems.

Change may come slow in this world, but it does eventually come. Almost 50 years ago, we saw the birth of our first completely electronic exchange, the Nasdaq, but while the NYSE has gradually moved towards electronic trading over this time, it took 50 years plus a pandemic to finally get them to go all electronic, although they were chomping at the bit to return to the mostly electronic trading that they have been using on this exchange lately, and have now picked that up again as fears have calmed enough to let traders back on the floor.

The NYSE and other exchanges that use floor traders claim that having at least some of a human element in trading is somehow better, but given that floor traders rely on technology as well, this argument cannot make sense, because even if they wish to keep all the side deals that go on with this method of trading, independent of whether this is a good idea for the market or not, this can be done remotely just as easily, more easily in fact.

This would require that such things be set up in advance though, much like working from home requires that you get set up for this, where people who wish to negotiate trades off the grid that these floor traders engage in be given the technological means to replicate and even improve the efficiency of these dealings.

This runs up against the principle of price discovery that is central to what a free market does, where people want to trade but don’t want it to show up on the tape like normal trades do. This isn’t as cut and dried as we may think, wishing to rid ourselves of these off-the-grid trades to make markets more transparent and efficient, but if darkening the room promotes more trading, due to some traders having the normal amount of light hurt their eyes, allowing this may indeed serve the purpose of driving more trading at least.

Apart from that, we’ve moved very much towards trading electronically, and COVID-19 at least got us a chance to see what completely electronic trading looks like, where the people in black did at least have to find a workaround, and it all went off very well. Floor traders will eventually be completely replaced, we’re just not quite ready for this yet, but for retail investors, the future has arrived completely.

Computers have fully taken over retail investing now, and not only that, we’ve finally sat down and thought out how this arrangement may help us expand the retail market, allowing us to fully serve all those people who never had enough money to participate or were put off by the old ways of doing things. You just pick up your phone now, log into an app, and don’t even need to buy a full share of anything anymore, as opposed to the 100 shares that served as the traditional entry point from the time stock trading started until very recently.

Kids can even take their meager allowance money and use it to trade stocks, and plenty of people have been using unemployment benefits to trade these days. You used to have to be fairly wealthy to invest in stocks in bygone days, but now we’ve extended this reach to everyone with any amount of money to set aside, even just a few dollars, even among homeless people who could use the spare change they collect to buy shares if they want.

This in itself is a grand achievement, where we have expanded access to the stock market to the point where it has now been fully democratized, where we have achieved so much efficiency by letting computers do all the work that everyone is now welcome and served at such a small cost that brokers don’t even have to charge for the service anymore. This is the ideal.

This recent revolution has been led by a previously little-known brokerage service called Robinhood, who actually have been around for over 7 years now but only very recently hit the big time. They’ve been offering commission free trading all this time, but lately, as they took off in popularity, thanks to social media, all the major retail brokers had to follow suit or lose even more business to this new kid on the block.

Commission-Free Trading Has Freed a Lot of People

Commission-free trading is a much bigger deal than a lot of people realize, those who might invest tens or hundreds of thousands of dollars into stocks and just let them set for years, people who probably wouldn’t quibble over $20 per round turn trade, because they make so few of them. There are folks who do dozens or even hundreds of these trades per day though, but commission-free trading does not just benefit frequent traders, it also benefits small traders, which is why this revolution is such a big deal.

The benefits to both types of people, frequent traders and small traders, are of a similar nature, as commissions require anyone who trades to recover their commission costs before they break even. You still have to pay the spread, but the spread is priced on a per share basis or fractions of a share, where commissions are per order, so you need a bigger order to spread around the commission costs enough.

If someone wants to buy a share of a company priced at $20, and the round turn commission is $20, the stock has to double in price before you even get to the point where you just have to cover the spread to break even. If you are trading, the same thing happens, where if you buy $1000 worth of stock, you need the price to move by 2% plus the spread before you even get your money back.

A 2% move to a trader is a huge move actually, and frequent traders will usually shoot for just a small fraction of this in a trade, and this will require them to stay in the trade a lot longer than they want or are comfortable with, and even when they do score a win, they will lose a big chunk of their profits to commissions.

Even the most skilled of traders cannot profitably trade with just this small amount of money, and even ten times this isn’t all that much and requires a lot more skill to be profitable than if these commissions weren’t charged.

Losing the commission charges is therefore a real godsend for traders, especially ones of more modest means, just as it is for investors who don’t want to pay a big chunk of their profits to commissions either. Not having to buy a full share anymore and allow partial shares to be filled by clearing houses is another huge shot in the arm for very small investors and traders, another Robinhood innovation that other discount brokers have also picked up to stay competitive.

No one cared about Robinhood when they were just a punk hanging around the street corner and collecting small change from passers-by, but things have really changed for them now. Online retail brokerage accounts have soared in 2020, and more than half of these new accounts were opened at Robinhood. They now lead the market in transactions per day. They are now far from being in the shadow of these big firms, and are handling four times as many trades as E*Trade, to put their current presence in perspective.

While we may think that Robinhood having so many more transactions than anyone else these days may not amount to that much, they have also moved up to second place among retail brokers in terms of the volume of the dollar amount of their orders as well, and are catching up to first place TD Ameritrade. This is a very big operation now.

The retail brokerage industry had been pretty stagnant in recent years, but Robinhood and their new way of doing business has breathed new life into the industry, where we have finally found a way to tap into all the unserved potential business that has been out there, and Robinhood found a way to tap into all of it, where no amount is too small to invest or trade anymore.

Robinhood also gets more than its share of criticism, which ranges from their helping drive the price of stocks up, which is a curious one because that’s what people want to see, to accusations of their encouraging their clients to make risky trades, particularly with options trading. This last one may have some validity to it actually, although not anything particular to them, even though they do seem to promote these things a little more aggressively than their competitors.

Many of us have seen the options commercials from TD Ameritrade, where they give their clients a few instructions on how to place advanced options trades, involving spreads, with the guy saying that the only spread he’s been introduced to is onion chive. That’s by far a more suitable spread as we cringe at the thought of newbie options traders who got a little info from their broker placing trades like this and being deluded into thinking that they know enough about what they are doing to have anything but a negative expectation overall.

At least you can’t get into as much trouble with options spreads as you can with writing naked options, where you can blow your entire net worth on and beyond. We really need much more regulation with options trading than we have, and retail brokers pushing these trades as much as they do does need to be looked at, not only at Robinhood but its competitors as well.

Retail brokers have about 10% of their business on the options side, which might not seem like that much but options trading is so much more difficult compared to trading stocks or ETFs that a number like this should alarm regulators a great deal. Just telling someone that options involve more risk doesn’t quite do it, especially if you tell this to a 20-year-old kid who lives for excitement and has no idea what they may be getting into, as the late Alex Kearns got to learn first-hand.

We Need to Both Enable and Protect Traders Enough

Kearns was the 20-year-old Chicago area college kid with no income who somehow was allowed to rack up $730,000 in losses with option trades placed with Robinhood that went horribly wrong, and unfortunately took his own life over this, and wondered in his suicide note why he was allowed to commit economic suicide. No one is even sure what the answer to this is, but this is why we need tight enough controls on extremely high-risk trades like this.

This is far from normal, surely as a result of a technological glitch, as Robinhood won’t be in business long by giving people with no income the ability to go that far in the hole, or anything remotely close. Still though, this was a wake-up call and one we finally did hear.

We need to distinguish between the truly absurd lack of controls that would allow such a position to run this far into the red with the general criticism that many have about Robinhood turning trading into a video game played on a phone, as anyone who has a problem with such a thing just doesn’t get the fact that this is all a game, they just play with bigger stakes with their bigger investments.

All investing, even the stuff that Warren Buffett does, involves placing bets on the future price of an asset, whether we are wagering a billion dollars or just a couple of dollars. We also get to decide how we are going to be betting our money, whether old fogies agree with our strategies and methods or not.

Somehow, it is seen as a lot less risky to not manage risk at all like investors do, to take on whatever pain the market may decide to lay on them, than it is to engage in shorter-term trading that allows traders to get out of town when the sky gets cloudy at all.

This is complete nonsense, although it’s been a popular view for years. The criticism used to be that traders kill themselves by paying all those commissions, where they only make their brokers rich, including giving them a good chunk of their principal, and in many cases that was a valid criticism and the reason why so many traders have gone broke over the years. When you place a lot more trades, and you aren’t skilled enough to overcome trading costs which include commissions and the spread, this just won’t end well.

This doesn’t mean that traders cannot make tons of money even paying commissions, even triple digit returns a year if they really know what they are doing, but most people who try this aren’t very good at it or have any idea how big the challenge really is. However, losing the commissions levels the playing field by a huge amount, where we still need to cover the spread to make a profit, but that’s far easier to do and at least we won’t have all those commissions taking us down.

Robinhood, in fact, has done more to reduce this undesirable situation than anyone, by a long shot. Sure, they target younger folks who are much more prone to gaming than investing, and have been completely taken by this game which is not only a game of pure skill but one that pays real money and not points if you win, but without having to pay commissions, their lack of skill is far less of a big deal on balance anyway. If you just placed random trades and knew nothing about what you are doing, the most you would lose overall is the tiny spread per trade.

We want everyone who wants to get involved in this game to be able to if possible. Robinhood has made this possible. We should all be happy about this and also extend people the same level of respect that we would expect for ourselves, where people do not try to impose their arrogant and limited views on others, thinking that they are trading too much and forgetting whose money it is and who really gets to decide this.

The practice of brokers getting paid for order flow is now more transparent due to the disappearance of commissions, but this is nothing new. No one is going to let you trade without the opportunity to make money themselves, where they need to cover their costs and do expect to keep a little in profit, and this money does not come to them by way of donations, these are actual businesses.

Some see these order flow payments as kickbacks, but what they actually do is reduce trading costs by having market makers purchase order flow from brokers, sharing the spread with them rather than keeping it all for themselves. These payments drive more volume to them and this happens to be what is being used in lieu of commissions, where the spreads haven’t increased, nor have the payments per order, but the retail brokerage industry has now become so competitive that brokers will settle for just these payments to get paid.

There are ways to still trade without any order flow payments changing hands, which shaves a tiny bit off of spreads, but without the order flow payments, brokers who offer this still need to get paid, and they charge commissions instead. If you are trading a six-figure account or higher, you may be better off with this arrangement overall, but this is more for professional traders, not retail ones, who benefit greatly from having order flow payments pay their way.

We still need to keep people from getting in way over their heads though, actually engaging in trades of a high enough risk that can get them in a world of trouble, especially writing naked options, where you assume all the risk past your strike price. This is the sort of thing that we should be requiring accreditation for, not investing in hedge funds, which is actually a pretty ridiculous requirement.

This does not mean that we want to limit options trading to those of high income or net worth like we do with hedge funds, but we should require that they at least receive a minimal level of education to at least have a better idea of what they are getting into. It’s fine to write an uncovered call or put, but we can’t just let people do this with no protection, and this is what spreads are for, to define our risk.

We should not mind seeing people whittling their accounts away, but we definitely should be concerned about their burning down the house. Retail brokers, including both Robinhood and their competitors, make a lot more per order from options order flow and they cannot be seen to overly promote this type of trading to profit more at the expense of neophytes who they shower with virtual confetti and try to psych up.

The criticism that Robinhood is encouraging options trading a little more than they should does have some validity, but if we’re going to try to fix this one broker, we have to do this industry-wide, and this has become a problem with retail brokers overall now. That’s why TD Ameritrade runs all those options commercials, because they make more off these trades now compared to stocks and ETFs.

The Facebook kids have showed up now though, in droves, and trading can be great fun, but at the same time we should want to make sure that they don’t get themselves in too much trouble. We especially should not be pushing trades which may not be suitable for people, especially when we lead them to believe that certain types of trades are the good stuff, when in fact they are much more difficult to make money from versus just buying and selling stocks straight up.

Robinhood has inspired a huge change in retail investing, and they should also be leading the way helping educate those 13 million traders and investors that they now have in their fold, to lead the way by being more responsible even if it does cut their bottom line a bit. This could be a big win for them if they did this right, much like commission free fractional share trading has been. The kids would come not only to play but to learn, and there is much to learn.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

Contact Ken: ken@marketreview.com

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