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Brokerages Dispatches

Execution Prices Vary Significantly for Commission-Free Trades

Brokers charging zero commissions does not necessarily mean “free” to the investor due to the practice of payment for order flow.

by Jack Gilleland | November 2022

Brokers charging zero commissions does not necessarily mean “free” to the investor due to the practice of payment for order flow.

Commission-free trades have become the standard in retail investing. But brokers are offsetting the revenue loss from commission through payment for order flow (PFOF). Payment for order flow is the industry practice of market makers paying brokers for the right to execute the broker’s clients’ buy and sell orders. This results in brokers directing their trading volume to certain market makers, which creates a potential conflict between investors and brokers.

A study found that payment for order follow creates trade price differences that are essentially the same as fees. The researchers studied trade price variation by opening individual accounts at five brokers and two accounts at one broker that offer accounts with and without commissions. The experiment examined E-Trade, Fidelity, Interactive Brokers, Robinhood and TD Ameritrade—the largest brokers in terms of volume of trades per day.

Large variations in execution price were found among the brokers. Across the six accounts used, the average cost of a round trip (a buy and a sell) ranged from –0.07% to –0.46% and the average price improvement varied from $0.03 to $0.08 per share. [Price improvement is when a trade is executed at a price more favorable than the best price quoted by the market.]

Notably, trades routed to venues with the worst price execution were found to have less variation than the actual variations the researchers observed. Rather, the observed variations were found to be largely explained by which broker the trade order came from.

There were limitations to the study. The researchers only focused on price execution for smaller retail trades, whereas institutional investors with large trades can more easily manage price impact. Additionally, the study only focused on market orders; other types such as limit orders may show different results.

The study concluded that individual investors have no way of determining the variance of price execution for brokers, and that increased regulatory action could help further disclose the execution statistics by brokers.

Source: “The ‘Actual Retail Price’ of Equity Trades,” by Christopher Schwarz, Brad Barber, Xing Huang, Philippe Jorion and Terrance Odean; September 2022.

Discussion

ROBERT A from NC posted over 3 years ago:

I almost always use limit orders, so as long as I get my price, it doesn't bother me too much if a broker skims some cream off the top. They have to make money somehow.


STEPHEN R from CA posted over 3 years ago:

I expected to see the brokers ranked on how well or badly the customers fared trading with them. Also, I didn't see a conclusion on how customers paying commissions fared against customers not paying commissions. Further research in this area with a report to AAII members might reduce the need for further regulation.


BARRY J from TX posted over 3 years ago:

The article says the average round trip cost is (-) 0.07% to 0.46% PER TRADE, and the average price improvement is (+) $0.03 to $0.08 PER SHARE or (+) $0.055. For example, if you round trip 100 shares, on average, you lose (-) $.07-$.46 on fees and gain (+) $3.00 to $8.00 on "price improvement or (+) $5.50." With that math, you GAIN on every transaction. That is not my experience. The problem with this "study" is that a counterparty pays for your gain. Sometimes YOU are the counterparty who gets the wrong end of the deal. The broker gives preference to internal holdings and preferred accounts on both buys/sells. On net we ALL lose ALL the time. No surprises here. I learned that "buy and hold" has even more value than I thought.


JAMES S from IL posted over 3 years ago:

I quite agree with BARRY J's remark that "[o]n net we ALL lose ALL the time"---not least because it applies not only to investing but also to many (or most?) other realms of human endeavor.


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