If trading is free, how does Robinhood make money?


When you place an order to buy, say, TSLA on Robinhood you might think that Robinhood finds a seller to match or routes it to one of the major stock exchanges. In fact, they sell the right to execute this trade to other companies, primarily high frequency trading (HFT) firms like Citadel and Virtu. This practice is known in the industry as Payment for Order Flow (PFOF) and is somewhat controversial, depending on whom you ask. These companies pay Robinhood fractions of a penny for every share routed to them. These fractions of a penny add up: in the first half of 2020 Robinhood's total revenue from PFOF was $280 million.

The other important thing to know now is that not all trades are created equal from a PFOF perspective. In general, options trades are more profitable to execute, and therefore Robinhood gets paid more for options trades than they do for regular stock trades on a per-share basis (by some estimates over 3x more).

Don’t worry about the details of PFOF yet, we’ll get into that later. For now all you need to know is:

More trades = more revenue for Robinhood; and,

More options trades = even more revenue for Robinhood.

Robinhood's approach to designing a trading experience was unique when it first launched. Get this: they actually wanted to make it easier and more fun to trade than legacy brokerage firms. The entire experience is built to eliminate any and all friction.

But as is the case with many binge-worthy apps, the line between delightful and addictive is blurry. You could argue they go too far (and many do). After a user's first trade confetti falls down from the top of the screen. This is a strong but subtle message that 'trading feels gooooood'. Later users will encounter experiences that make it easier to complete a trade than to cancel it. They'll see stock recommendations as if this was Netflix. The buttons to trade options will be placed above buttons to simply buy a company's stock. All of these combine to create a powerful psychological pull to keep trading, and to take on increasingly more risk.

Robinhood didn't invent PFOF—although the names Bernie and Madoff are involved in its actual origin story, which may explain in part why PFOF is considered sketchy—and is not the only firm engaged in the practice. What is strange is that the HFT firms pay 5-100x more per share to Robinhood than they pay to Schwab or ETrade.