Where’s The Money Coming From?

I know, I know…it’s been an age since I posted here. The world has been a very strange place for the last year. The fact is I still have some issues with posting trades when so many people are suffering from this horrible virus — be that directly (medically) or indirectly through the social and economic effects. As someone in the privileged position of having already worked from home for decades, as someone who has not been put out of work because of the pandemic, it feels wrong to show money being made in comfort.

So I’m not posting here today to show any recent trades. And I’m certainly not posting to talk about GME, AMC or BB or any of the other hot stocks that have got everyone excited, except to say personally I’d steer well clear of anything getting that kind of media attention. Volatility is good, but when so many people with essentially no idea of what they are doing start pouring huge amounts of money into the market, things can go pear shaped quickly. Like brokers ceasing the trading of a stock, for example (more on that in a second). There’s no shortage of nice easy predictable trades that can put a decent amount into your account day after day without any drama. No need to start jumping on bandwagons. Especially ones where the wheels are held on with little more than hope.

The recent week’s news has prompted today’s post though, just not for the reasons you might think. What has driven me to put fingers to keyboard for the first time in months is the volume of messages I’ve been getting about so-called zero commission brokers, which are getting a disproportionate amount of time in the spotlight thanks to the aforementioned stocks.

These ‘brokers’, and I’m not going to single any out or mention any names, generally come in the form of apps. I can see the appeal — to the uninitiated, the thought of downloading a free app, plonking some cash into it, and then making your fortune in the stock market without spending a dime on commissions sounds too good to be true.

Uh-oh…you know what they say about things that sound to good to be true…

An Illusion

The first thing to understand about these apps is that they are not really brokerages. Not in the sense of that any professional trader would recognise. They are more akin to CFD and spread bet outfits.

When you place a trade through these apps, there is almost no chance you actually become the owner of any stock. Instead your trade is settled internally within the ‘brokerage’ (quotes because as I said, they’re not really brokers). It’s pooled with other orders, and the ‘brokerage’ hedges their overall position in the underlying market.

Because you don’t actually own any stock, the price you get may or may not reflect the real stock price. This is the case both on entry and exit. You are in effect trading a derivative.

Most of the time this is probably fine. In a slow moving market, things trundle along nicely. The app prices largely follow the underlying price, the traders working the back room hedge and trade and make sure that they are always in the green, and everyone is happy.

But when things move quickly, it can all go pear shaped rather fast. The ‘broker’, if you read the small print, has no obligation to match the underlying price. They don’t even have any obligation to let you trade. Which is precisely what we saw last week, when a lot of non-professionals who thought they were going to make a killing jumping on a bandwagon found themselves holding the bag — locked out of a market with prices plunging.

Follow The Money

Not all zero commission traders work this way. Some do actually execute your trade in the market. The question we have to ask, as professionals doing our due diligence, is this: where’s the money coming from? By which I mean: a brokerage is a business, and a business exists to make money. If your broker isn’t charging you commission, where’s their money coming from? The staff have to be paid somehow. The investors in the business are not a charity, they’re expecting a return. So where’s the cash coming from?

Usually the answer is simple: the spread. Yes, your trade might get executed in the real market, but at what price? If your so-called ‘zero commission’ broker is taking more than a penny off the spread, you are actually paying over the odds for every trade you make.

Cost of Business

I’ve written before about how brokerage fees are a cost of doing business for a professional trader. Every business has costs. A taxi driver has to pay for fuel, tyres, maintenance, and insurance. A builder requires a whole host of power tools. Sure, they might get away with buying the cheapest kit for a while, but the false economy comes back to bite when the poor quality equipment fails on the job.

As professional traders, we too require professional tools. A fast, reliable computer and internet connection are a must. Quality data is a given. And a reputable, reliable broker is part of the set. We need to know our trades will be routed to the underlying market at the best price. We need to know we’ll be able to open and close trades at will. And we need to be sure we’re not going to be cut off from the market because the venture capital that’s keeping our broker afloat just ran out.

That’s not to say these zero commission apps don’t have a place. They can be useful as a way of dipping a toe in the water, to find out if trading is something that appeals. But for anyone taking the trading game seriously, serious tools are the order of the day.