The Hidden Costs Of Commission-Free Trading

© 2019 Bloomberg Finance LP

Over the past few days, online brokers have rushed to roll out commission-free trading deals, but is there a catch?

Robinhood started the trend of free trading. Recently, other brokerages jumped on the bandwagon. Late last week Interactive Brokers previewed IBKR Lite to offer an unlimited commission-free trading service. Then Charles Schwab and TD Ameritrade jumped on board, with Ameritrade including options as part of the commission-free offer. So what are the implications for investors?

A Good Deal?

This is a good deal for consumers, right? The fact that the stock prices of major brokerages have fallen materially on the news suggests this the market sees this eating into their profits, and perhaps, by extension, helping customers. Of course, something you use being available for free is generally a good thing. However, in the complex world of trading a few caveats are worth mentioning.

The first is that free trading may cause bad trading behavior. In the markets, medium- or long-term investment decisions are generally better. This paper supports the view that long-term holding periods can lead to better investment outcomes and short-term trading driven by overconfidence can be misguided.

So free trading may save you money on trading costs, but if it causes you to trade rashly,  your returns may suffer. For most investors, investment returns are a much bigger deal than trading costs. Therefore, being able to trade for free  can be counter-productive if it tempts you to become a day trader and tank your investment performance. What do I have against day traders? Well this study showed that the vast majority of day traders lose money after fees, further bolstering the case for longer term investment horizons. If commission-free trades create more day traders, that's probably a bad thing.

There are other risks from free trading---namely, that brokerages may recoup the costs in less transparent ways. The first is by widening the bid/ask spread. You may have noticed that when you trade a stock in your account you almost instantly lose money compared to the market price. This is because of bid/ask spreads; to compensate the market maker for constructing a market in a stock, you typically don’t receive the market price when you buy or sell. You pay a little bit more than the prevailing price when you buy and receive a little less when you sell. Of course, a brokerage may provide an unattractive spread for you regardless of fees, but the absence of trading commissions means that less efficient trading could be a way for brokerages to capture revenue from trades in a way that’s less obvious to the customer, such as routing trades in a way that leads to wider spreads.

Another means of making money without charging the customer is to sell order-flow data. This can disadvantage you too, because the data can be used by other market participants to arbitrage activity around short-term trades, potentially your trades. Here using limit orders and having some patience may help. If you place a limit rather than a market order, it’s a little harder for your trades to be taken advantage of. However, there’s also some risk the trade doesn’t get placed if the market moves away from you.

So commission-free trades are almost certainly a good thing for investors. Still, don’t necessarily think that they offer an excuse to trade more as that may hurt more than it helps. Be wary that brokerages may focus on making money from you in other ways now that trading is becoming commission-free.

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Simon is Chief Investment Officer at Moola, and author of Digital Wealth and Strategic Project Portfolio Management. Articles are informational only, not investment advi...