They use Payment for Order Flow: https://en.wikipedia.org/wiki/Payment_for_order_flow
(Just like Robinhood - https://support.robinhood.com/hc/en-us/articles/360001400766...)
(Just like Robinhood - https://support.robinhood.com/hc/en-us/articles/360001400766...)
Payment for order flow means that whoever is getting your orders (schwab/robinhood) is getting paid to send them to a specific market maker: https://www.citadelsecurities.com/
The Market maker is holding lots of securities that they want to sell. They also buy securities (to then sell.) They are trying to make money on the spread, meaning "buy low sell high". Market makers provide liquidity in that their whole goal is to not "invest" but to enable trading by being willing to buy and sell.
As for the actual execution of those trades, that's out of my depth, but someone else may be able to fill in the gap.
> Does that make me uninformed?
I don't think so, I think if you are trading on a strategy that competes with HFT approaches then you would be "uninformed" but to the "average" buy and hold or buy and sell in a few days, all of this shouldn't have a large impact on your bottom line, it should actually enable it.
Equities are not like this; there are "market makers" who will buy whatever shares people want to sell, and sell whatever shares people want to buy. For a given stock, like AAPL, maybe market makers are willing to buy shares for $218.38, and sell them for $218.79. The difference ($0.41) is called the spread. On a good day, they'll buy your shares for $218.38, and resell them a few seconds later for $218.79, pocketing the $0.41. Repeat over and over, and you'll make some decent money.
Those quotes are updated rapidly in response to events and changing supply and demand. When prices changes, a market maker can lose (potentially a lot) of money. If Apple announces terrible quarterly results, the "true" price of their shares might suddenly be $150; if you sell all your shares to a market maker for $218.38 before they realise, they'll be facing not a gain of $0.41 per share, but a loss of $68.38 per share.
Market makers work around this by 1) charging a big enough spread that they can eat the occasional loss and 2) by trying to react as fast as they can. Still though, it happens - you never know if the guy who just hit your quote is some guy day trading a few thousand dollars during his lunch break, or if this is just the first part of a hedge fund unloading a few hundred million dollars, so you have to be pretty twitchy, offering wide spreads, and updating prices quickly.
It also follows that if you could somehow be sure that your orders were coming from retail investors, then you wouldn't have to worry about any of that! The orders would be safe to execute, and could be profitable even at very narrow spreads.
US law says that everyone must get execution at least as good as the best posted price (the NBBO), but the NBBO has to take into account that the person on the other side might be a hedge fund; it'll never be THAT good a price. So if you found a source of guaranteed retail orders, you could offer them a private "better than the best" price; that's called "price improvement". Or alternatively, you could offer them the normal public best price (the NBBO) and pay the broker a rebate for sending you the orders (that's called "payment for order flow"). And then your broker might pass the payment for order flow on to you in the form of free or cheaper services, or they might just pocket the money.
So when your sell 20 shares at $10, what's happening is you're selling shares at $10.00 each to a market maker, who is confident that someone else is going to buy them back off them for $10.05 (or whatever). And in fact, although the best publicly available offer is $10.00 (which is what you got; you'll never get worse), if the market maker is sufficiently convinced you aren't secretly about to sell another 9,999,980 shares in the next millisecond because you're actually an algorithmic hedge fund scraping twitter feeds to find out financial news before anyone else, then they might be willing to pay $10.02 for your shares instead, because they don't have to worry about the price changing before they can flip it. Or they might pay $10.00, and kick $0.02 back to your broker, who will use that to offer you free trades, which may or may not be a better deal for you.
Said another way: The big guns will likely beat you, and you over time with LOTS of trading may lose a few % but for most small fries it shouldn't even matter.
That said, it looks like Robinhood is making more than most on their orderflow:
> In September 2018, Logan Kane, a contributor to Seeking Alpha, stated that Robinhood's payment for order flow generated ten times the revenue as other brokers receive from market makers for the same volume. Bloomberg has analyzed Robinhood's reports to the Securities and Exchange Commission (SEC), and calculates that Robinhood generates almost half of its income from payment for order flow.
https://www.investopedia.com/articles/active-trading/020515/...
As a small-time investor, you can trivially get a better price than larger investors. And you must, by law, get the National Best Bid and Offer (NBBO) which is, at least for some purposes, the "best price".
The deck is heavily stacked against retail investors trying to actively invest, but the issue isn't being unable to get good execution!
Robinhood's apples weigh more than Schwab's oranges, because Robinhood encourages users to do options trading (and be more active on it) and Schwab does not. Spreads are wider in options, because they're less liquid, because they're (mechanically) larger trades [+], and because the degree of volatility in options prices is higher than therefore market makers have to charge higher spreads to justify the risk. High spreads mean happy market makers, so the amount you can charge a market maker for "Here's a retail order; would you like to collect the spread on it?" is higher.
[+] Options contracts represent, typically, 100 shares. The notional exposure of 1 options contract on e.g. Google at a strike price of their current price is high. If you measure the other way, by transacted trade size, the spread on a $500 order of Google should be denominated in pennies and the spread of a $500 order of Google options will could be hundreds of dollars for a sufficiently illiquid strike/date combination. (e.g. Consider a put on Google at a strike price of $100 in late October. Google currently costs ~$1,200 a share. If you believe it is likely that Google declines by over 90% in October, and want to express that belief in an instrument, the financial industry can assist you in doing that, but the spread on that particular product will probably be wide. Without checking the quotes at all, I'd predict no buyers at any price and ample sellers at 5 cents a share. If you put in a $500 order expressing that view, you are paying ~$0.01 for the instrument and $499.99 for liquidity.)
As a small-time, retail investor, you are statistically guaranteed to make random, uninformed trades, and it is profitable for market makers to process them, in much the same way that it's profitable for a grocery store to sell you groceries. And much like the grocery store selling you potato chips, they make their money on volume, not on gouging you on the cost of staples.
Whether you should be buying those chips (or day trading AAPL) is a question for you and your dietician and/or investment advisor, but you don't need to worry about the price.
But the markets aren’t a random walk and even if you are just buying indices, you still have to actively manage them. Namely you have to decide asset allocation, leverage, industry, country exposure, etc. Also you have things like style exposure to consider as well. As such, there’s really no such thing as passive management.
Also, actively trading beta isn’t exactly the hardest thing in the world. Even though some players move extremely quickly over market news like Trump tweets, trade war announcements, etc, it still takes a couple days for all investors to react to the news. In fact, retail investors are often better positioned to quickly react as the slippage on their trades is non-existent for all but the most illiquid names.
In short, I wouldn’t recommend actively trading for most people. But those people are still going to need to choose some allocations and rebalance once in awhile. For those that are interested, retail alpha isn’t that hard to find, especially with leverage.
(skip forward to the part where it says "Robin Hood", it's just part of his column that day)
tl;dr You're not getting screwed by Robin Hood (as a matter of fact, they're good for you), but Robin Hood is enabling you to make trades you shouldn't be making in the first place because you're probably unsophisticated.