How Robinhood is Capitalizing on the Options Boom

The practice, called pay for order flow, has made the option a cash cow for brokerages such as Robinhood Markets Inc. and TD Ameritrade. They can earn twice or more from selling clients’ option orders as they do from selling order flow for the stock.

In the 12 months through June, the 11 largest U.S. retail brokerages collected $2.2 billion for selling clients’ option orders, according to Larry Tabb, head of market-structure research at Bloomberg Intelligence. This was almost 60% higher than his sell equity order.

During that period, major brokers were paid an average of about 16 cents for every 100 shares of stock orders their clients had, compared to about 54 cents for options orders of similar size, data from Mr. Tabb. Show.

While the payments are legal and have existed for decades, they came under renewed scrutiny after January’s trading frenzy in GameStop Corp. The Securities and Exchange Commission is reviewing payment for order flows, and its chairman, Gary Gensler, has said the agency is open to banning the practice.

Critics say that pay for order flow has reshaped brokers’ business models to enable them to take advantage of more trading activity from clients, sometimes via gamelike smartphone apps. Some warn that large order-flow payouts from options activity can effectively push inexperienced clients into risky trades they do not understand, leaving them with large potential losses.

“There are conflicts of interest here,” said Paul Rowadi, director of research at the Alfaquation Research Conservatory, a market research and advisory firm. “They’re going to push you to Lamborghini, not Bronco.”

Brokers such as Robinhood say this practice broadens their access to investments by allowing them to have zero commissions. “Pay for order flow, along with technology, has helped make investing less expensive and more attainable for millions of investors of all backgrounds,” said Dan Gallagher, Robinhood’s chief legal officer.

A spokesperson for TD Ameritrade said that the firm “does not offer clients incentives to trade options” and that investors become interested in options as they gain experience.

Options provide the right to buy or sell shares at a specified price by a specified date. They can be used to defend or to speculate. More than 38 million options contracts changed hands on an average day in 2021, up 31% from the previous year and the highest level on record.

Robinhood reported last week that it earned $164 million from sell option order flow in the third quarter, more than three times more than such payouts associated with stock trades. The firm has said that about 13% of its clients trade options, meaning that higher options revenue comes from a smaller slice of Robinhood’s user base.

Option payments accounted for 45% of Robinhood’s total net revenue in the third quarter, while the other two types of order-flow payments the firm received — for cryptocurrencies and stocks — both accounted for about 14% each.

The largest sources of payment for order flow are electronic trading firms such as Citadel Securities and Susquehanna International Group LLP. Such firms make more consistent profits when trading with individuals than other large, sophisticated traders. In order to win more business from small investors, firms pay a brokerage for the order flow.

Traders and exchange executives say that brokers get paid more for options than for equities because the potential profit is higher for firms that execute investors’ option orders.

Why over here Firms such as Citadel Securities and Susquehanna are market makers. This means that they trade stocks or options throughout the day and collect the difference between the buy and sell price. These “bid-ask spreads” are generally wider in options than in stocks. For example, the average spread in Apple stocks was about 1 percent in September, while the average spread for Apple options was about 14 cents, according to data provider Maestreet.

The difference is partly because Cboe Global Markets Inc. According to U.S. data, there are more than 2,000 types of Apple options, with several having strike-price levels at which investors can exercise their right to buy or sell. With a large number of contracts, many of them have low price quotes, resulting in a wide bid-ask spread. Wider spread means more profit opportunities for market makers and intermediaries such as brokerages.

Compared to stocks, “it’s a very different market structure,” said Joanna Fields, founder of consulting firm Aplomb Strategies. “There is very little liquidity on each strike.”

Some traders say that the complex structure of the options markets further encourages pay for the order flow. SEC regulations require investors’ orders to be executed on any of 16 US options exchanges. Exchanges typically pay discounts to market makers who deliver orders from individual investors to their marketplaces. They increase the payout going to discount brokers.

In theory, market makers compete on options exchanges to fill each order at the best price. But that doesn’t happen in practice, said Michael Golding, head of trading at market-making firm Optivar US LLC. Instead, firms that pay for order flow often send investors’ orders to exchanges where, according to Mr. Golding, they are likely to execute the order themselves. A complex system of exchange fees discourages other firms from competing to fill those orders, ultimately hurting investors, who may not get the best possible price, he said.

“This is what the SEC really needs to look at,” Mr Golding said. “Who is taking care of the investor in this whole scheme?”

Ever since brokers cut fees for options trades in late 2019, individuals have piled into options. The influx accelerated with the covid-19 pandemic and this year’s meme-stock craze. Retail traders accounted for nearly one-quarter of all options activity in June, up from around 21% in January 2020, according to AlphaQuation’s estimates.

In its October report on GameStop Frenzy, the SEC suggested that Payment for Order Flow encourages brokers to design “gamelike” digital apps that prompt their clients to place too many trades.

Brokers have long made money from trades by charging commissions. But new firms like Robinhood rely less on traditional revenue streams, such as collecting interest on cash balances, that are not volume-driven.

Unlike brokers, investors do not profit from repeated options trading. Research has shown that people who trade options usually make worse returns than those who stick to stocks.

Robinhood has already come under scrutiny for certain options-related practices. Under regulations designed to protect new investors, brokers must check their age, income and investment experience before offering trading options to clients.

In June, the Financial Industry Regulatory Authority found that Robinhood had approved thousands of ineligible clients for options trading after being sent through the firm’s automated approval process. Robinhood paid $70 million to settle that and other FINRA allegations, without admitting wrongdoing.

Robinhood says it has made its approval process more rigorous. A TD Ameritrade spokesperson said: “Options carry unique risks and are not for everyone, which is why not all retail clients are approved to trade options.”

This story has been published without modification to the text from a wire agency feed