Broker Wars

Buenos dias senors y senoritas! I’m back at it again while Mole is recovering from carving out cPanel from two websites. If you’re not up on web hosting, cPanel is the thing that allows simpler humans like myself to login to a website, create a directory on the website and upload pictures. Or install WordPress with 1 click. Just about every website in the galaxy uses cPanel as the backend, regardless if it’s WordPress or X-Cart on the front end.

Recently, cPanel was acquired by a investment firm that put their team of pricing people on it and decided they could substantially raise the price on cPanel with little consequence. So they did. However I disagree with their assessment, there will be backlash, in the form of a slow death. Why? Well let’s talk about brokers first.

If you’re not on the up-and-up, almost all of the brokers have gone to a commission free pricing model for stocks and $.65/contract for options. It started with Charles Schwab and then all of the brokers followed into the pool: Etrade, TDAmeritrade/ThinkOrSwim and even TradeStation if you use their web or mobile app to place trades.

Lots of my friends have been asking me, there has to be a catch? No commissions? Are the spreads going to widen and we’re going to get slow shitty fills with retail brokers? How are they going to make any money?

The first thing to keep in mind that all of these brokers are businesses and just like California, they are in-it-to-win-it. They are not charities. They are for-profit businesses and they will still be making fat stacks of platos, though this move will probably impact their bottom line by 20% – 30% short term since commissions are gone.

The way most big brokers will still make piles of cash on your trading activity is through order flow and a small amount from exchange rebates. I’ve been pretty deep down the rabbit hole of the trading world and the cliff notes version of it is the market makers run the show. Period. They don’t care which way the market is going, they are making money as long as people are trading. Just like the brokers.

Since market makers are looking to make the spread over and over again, they pay brokers to send them their orders. As such this is paid order flow, the brokers get paid for sending their orders to large market makers. It adds up, if you place an order for 2000 shares of AAPL and the spread is $.02, the market maker is making $40 on the spread and probably kicking around half, $20 of that back to the broker. So removing the $5.99 we were paying for a trade cuts down their gross by about 20%.

Another question people have asked me is: but won’t the spreads widen? They have to make their money somewhere! No, the spreads will not widen. Long term, they will shrink. Brokers don’t control the spreads, market liquidity and volatility drives spreads. In thin markets or volatile, market makers widen the spreads. In liquid markets, their are tons of participants making markets and they are undercutting each other to try to get a piece of the pie.

If market makers start to widen spreads, HFT players will be set up shop and shrink them.

Post 10:15 AM, take a look at the spreads in WYNN which is trading around $104 and AAPL which is trading for a lot more. Even though AAPL is much higher priced, spreads are typically $.01 – $.03 in AAPL, while they can easily be $.05  – $.07 in WYNN. There just isn’t much volume in WYNN compared to AAPL.

The real reason the brokers went to commission free models? At the end of the day, the big players know 1) it will hurt the smaller players like TastyTrade and 2) it will drive more trading. The market makers win. They ALWAYS win. The idea is to keep us trading as much as possible, when in most cases it’s not beneficial for a lot of people to be trading as much as they do.

Let’s pick on Think or Swim. Mainly because the Mac version of their client sucks ass gonorrhea and crashes all of the time. But I still love them.

Here is a snap shot from their client showing the uneducated trader tons of stats. Shit, this stuff must be actionable and mean something, why else would they put it in the platform?

The reality is 95% of the information on this screen is just noise that has no edge. The only important piece of information here is the current implied volatility and the IV percentile, which tells us how high or low the current IV is in historical terms. Here, it’s 72% which tells us that the IV is relatively high in SBUX.

That information, along with the 1000s of useless indicators that have no edge, are there to keep the uneducated trader hopelessly in a Red Bull infused foaming at the mouth trance with 10 monitors running. It’s pure mind fuckery. All of that information is there so you have an ADD sea of blinky shit that you believe is actionable so you keep trading. Your best financial interest is the least of their concerns.

Free trades are going to cause 90% of the retail population more harm than good, since most of their trading activity results in loses. It just makes it even more enticing to enter the casino, it’s the equivalent of free stiff drinks while sitting at the blackjack table.

This is how the game works. The market makers are running the show, they are at the top of the food chain. The brokers job is to make trading exciting and engaging for us so we keep trading. It also works the same way in the prop trading world.

After seeing most of the successful traders (with large accounts) pack up and go back to retail, I realized most prop firms make the majority of their money from fleecing small account traders with insane fees. Not from trading profits. It’s the Buy-Here-Pay-Here car lot of trading, especially for small accounts.

The Song Remains The Same.

The good news is if you’re a profitable trader, your transaction costs just got cut substantially and there is no gimmick. And they will likely shrink even more (slippage) in the future as spreads shrink in stocks and options.

This is such a big deal that when my capital is free, I’m 99.9% likely peacing out of the prop world, handing over my Series 57 and returning to the retail ranks.