The Real Cost of Zero Commission Stock Brokers + Why Are Some Cheaper Than Others?

In a recent study, the authors opened accounts at six different brokerages with their own money and executed 85,000 market orders. They discovered some interesting details about the actual costs of making trades using “zero commission” stock brokers. Here is the research paper The ‘Actual Retail Price’ of Equity Trades as well as coverage by WSJ and Matt Levine. A few takeaways:

“Zero-commission” does not mean “free” trading. There is always a cost due to the gap between buying and selling prices (bid-ask spread). If you bought and sold the exact same share of stock again immediately, you will almost always end up with less money than before. For example, you might buy a share for $100 but only be able to sell it for $99.95.

How much? The study found the average round trip trade cost ranged from –0.07% to –0.46%; the average price improvement varied from $0.03 to $0.08 per share (~$100 value). If you are an individual buying a low-cost index ETF and holding onto it indefinitely, this remains a small concern.

Heavy traders still face an uphill battle. However, if you are repeatedly trading for an extended period of time, the transaction costs of your “free” trades are still going to add up rather quickly and your odds of profit will diminish significantly. Here’s what happened when they repeated kept trading $100 back and forth on Interactive Brokers Pro and TD Ameritrade.

In fact, the authors of the paper had to reduce their standard trade size from $1,000 to $100 because they knew they were going to lose too much (of their own) money. (They first confirmed that the trading costs in terms of percentages was basically the same for $100, $1,000 and $5,000 trade sizes.)

The difference between the “best” and “worst” broker was 5 cents per $100 roundtrip trade. Will the average individual trader switch brokers over this amount? I would value things like customer service over this small cost. Yet, if you add up all the trades that happen during a year, it is billions of dollars going somewhere. Here are the six brokers ranked (graphic via WSJ article).

The study found almost no relationship between the amount of Payment for Order Flow (PFoF) accepted and lower execution prices. In fact, IBKR Lite is the arm of Interactive Brokers that accepts payment for order flow (PFoF), while IBKR Pro does not accept any PFoF. Yet, IBKR Pro had the worst execution for the authors’ $100 trades.

The strangest finding was that the market makers are giving different prices to different brokers for the exact same trades. This is the “industry secret” they uncovered. One implication is that each broker is negotiating “when” the market maker overcharges you or undercharges you based on their customer base. For example, Interactive Brokers implies that their “Pro” customers have larger average trade amounts, and thus they may offer those types of customers better execution (while giving worse pricing to the small trades, thus their poor showing in this study).

Bottom line. PFOF may not be huge deal for any individual investor, but there are still billions to be made skimming off pennies on every trade, and thus weird shenanigans arise. However, if you are an active trader, there is still a steady transaction cost to every stock trade which may not be readily apparent. You think you can trade in and out for “free”, but don’t see that the real cost is that you are pursuing the wrong way to invest.

How many people do you know that got rich by buying and selling stocks hours, days, or weeks later? I certainly don’t know of any. Meanwhile, I noticed the following in my Public app stock feed (see transfer bonus) for Berkshire Hathaway. I’m sure there may be good reasons in some instances, but it’s concerning to see how short these holding times are for a stock like Berkshire which is built for long-term, patient ownership.