The purpose of a business is to make money, plain and simple – and the stock brokerage industry is certainly no different.
‘Conflict of interest’ is the term that probably best describes the problem surrounding the information asymmetry between amateur traders and their brokers. You should carve it into the inside of your skull, so you’re always reminded when you get a notification from your broker that “now’s the time to buy” their latest “stocks of the week” selection.
I’ve tangentially touched on the subject in previous articles (e.g. here, here). However due to the extremes that the amateur trading community has brought to the market in 2020/21, and the continuing dominance of questions on online forums asking which brokers are “good”, I feel the need to give a more detailed account of how there are really no “good” brokers – only less exploitative ones. That is, there are of course individuals working at brokerages who may be good people, but brokerages as a business are certainly not.
Because, if one thing is for certain, your broker is not your friend. How could they be, if their entire business model revolves around your order activity?
You shall see that a broker, for their own good, has every motivation to have you trading as frequently as possible, as large as possible, to borrow as much money as possible … and on occasion, to be as wrong as possible.
I’ll briefly outline 5 ways that your broker could be (and with some of them almost certainly is) making money off you – whether you turn a profit, or not. I’ll discuss commissions, order spreads, outsourcing loan interest, pushing products and education that work against the client, and outright betting against the client.
I’ll start with the less ominous ones, and end with the more morally repulsive ones.
Although brokers are (still) a necessary evil, we should always be aware how what’s best for the company is seldom aligned with what’s best for the client.
As you will see, in some case, you making money is actually a problem for them.
In other cases, the old marketing wisdom applies … If the product is free, congratulations – you’re the product.
I’ll also try to give some advice on choosing brokers. Nonetheless, the wider benefit of this article will be gained just by being able to see through their business model, and understand how it attempts to manipulate the actions of the amateur trader. Such may or may not help you in your decision to choose wisely, or rather, how to interact with your broker (and the market) once you’ve chosen one.
Let’s have a look how one of the oldest businesses on Wall Street, is managing not only to survive but to thrive and make generous profits … by slow-dripping money out of customers’ pockets into theirs.
A brief clarification – I’ll be discussing straight-up retail brokers – no scammers, no pump-n-dump criminals or “Wolf Of Wall Street”-type penny-stock pushers, but also no institutional brokerages. I’ll be talking about the lawful retail brokerage houses and online platforms here, those following the regulations put out by regulators who are commonly decades behind the formers’ latest tricks and mischief.
#1: The Midas touch – Generating Commissions
Remember the old scene from the comedy Trading Places? The rookie William is told “No matter whether our clients make money or lose money, Duke & Duke get the commission”.
It’s the oldest piece in the repertoire of any type of broker in any industry, and stock brokerages certainly make no exception here. If you place a sell order, the broker goes out and matches you with a buyer – for a small cost of course. The buyer’s broker of course gets their own commission.
You might also have seen ‘fees’ appear on product flyers in the small print. What’s the difference?
Well, it’s like government taxation. It doesn’t matter what you call it – levy, tariff, duty, toll, excise, impost, defense/healthcare contribution – if the government takes it, it’s a tax.
In the same line, if the broker takes it, it’s a commission – whether you call it commission, fee, charge or whatever.
Commission is usually paid on a percentage of trade size basis, but with a required minimum always charged, and often some baseline “fee” needs to be forked over additionally.
Larger sizes cost more commission – for example when amateurs that are commonly so inclined buy tens of thousands of shares in penny stocks.
And more frequent orders bring more commissions.
Starting since the ’90s, stock brokers have started a competition in undercutting each other in commissions – the lower the nominal ‘commission’, the more competitive appeal to prospective clients. Low-cost and no-commission brokerages have started popping up like mushrooms everywhere, and many of the larger houses followed suit in order to stay in the game.
First, understand that no one is giving onerous phone orders to the broker anymore, as up until two to three decades ago. Everybody is placing high-speed internet smartphone orders from their bedroom or the bus. Though commissions might have come down, market accessibility and thus small order volume has grown magnificently, more than making up for the reduction in commission.
Some of those who have lowered ‘commissions’ have just replaced the terminology with e.g. fees or charges, some of them hidden in the small print. The result is still the same – you paying them for order execution.
Others have indeed reduced or done away with commissions and fees completely – and you may read below how they recoup their profits elsewhere creatively.
The original idea of the commission is probably the most honest type of profit a broker makes, so I got it out of the way first. They render a service for you at which they and their networks are good at (matching buyers and sellers), and you pay them for this service.
So far so good.
However, problems arise when the mentioned conflict of interest kicks in over time – because, if order executions make money for the broker, isn’t it in their interest to incentivize the greenhorn traders to place as large orders as frequently as possible?
….why, yes.
Read more on this as we plough through the other income sources.
I’d rather have the broker make profits from commissions than via shady operations. But I also won’t pay through the nose. Nowadays, you shouldn’t have to pay more than 5-10 basis points (0.05-0.1%) of your order $-amount as commission/fee/etc. per trade.
Reject exploitative brokers that insist that it’s “industry standard” to still charge you 1-2% of your order size – it’s not.
#2: The middleman’s cut – Order Spreads
Although you’ve seen that a stock always has a single price quote at a given time, this is only the ‘equilibrium price’ that a market maker sets. At any given time, there will be tens to hundreds of thousands of so-called limit orders sitting just above and below that price. This is where people want to buy and sell to make a small bargain, called the bid and the ask or offer prices – and the distance between them is known as the bid/ask spread.
Imagine Client A sees a stock at $20 and wants to buy there. Well, what you want and what you get are often not the same. Where you will actually buy or sell depends on your fill (i.e. the order execution price) – and only the broker is in charge of that.
That is because a huge number of client orders are not limit orders, but market orders – i.e. the broker is given the discretion to find the best price for the client at a given time.
You can see some leeway developing – the broker will be inclined to stretch the numbers a bit, 0.1% here, 0.2% there, for his own good.
For the above example, a broker for client A (who wants to buy at $20) might buy the stock the client wants at $19.95 on the exchange and sell it to the client at $20.05. The broker makes the $0.1 middle, while the clients are told there is some “slippage” in their order execution.
This happens millions of times a day – Little by little, the bird builds its nest.
The larger the broker and its accessible network, the higher volumes they can handle, the more liquidity they provide to the market and traders (which is good) and thus they can offer tighter spreads (better fills for the clients) to stay competitive with other brokerages – but with high order volumes even tight spreads are still lucrative for the broker.
Let’s come back to no-commission brokers. Business is business. They need to make profits somehow. You can make money on spreads, sure – but there is an even more profitable way – wholesaling bundles of client orders to someone else to make a spread.
This sometimes happens, and is known as the notorious “payment for order flow“, where your orders are routed to market makers, investment banks, or other institutional trading houses before the exchange, or to be internalized entirely (i.e. the order filled by them personally). The broker gets paid for that, and most clients never know this happens because it is buried deep in the fine print of their contract.
Those players get your orders and then make a spread profit by fulfilling your order after they acted profitably on it first. Imagine this happening a thousands times a minute and millions of times a day – good income.
There is nothing you can do here, except choosing more reputable brokers that have access to larger trading networks and can thus offer tighter spreads and better executions.
Only scalpers and day-traders really need to use limit orders, because for them, small spreads make all the difference. But if you use a limit order, you might not get a fill at all, the market might slide, and you might sit on a loss instead. A market order always fills, though not necessary exactly where you want it.
Bottom line is – if you have to fight over a 0.2% slippage, your strategy sucks. I recommend you choose to speculate in the larger multi-month moves of the best leading stocks – first because short-term volatility for day-traders has nearly been destroyed by algorithmic and high-frequency trading in the last two decades, and second because if you have 250% paper profits, a 0.2% lower fill from a market order is not going to make a difference.
#3: Of loan sharks and time bombs
Most amateur traders (or “investors“, as they like to call themselves) start with relatively small accounts (commonly between 2,000$ to 50,000$ account deposits). While a skilled speculator can grow such capital significantly, it doesn’t throw off a lot of profits for those who don’t have a strategy that does not capitalize on large market movements and uses margin intelligently.
Most amateurs don’t have any strategy at all, and thus they will quickly fall into the trap of trying to cut corners. They will naturally go looking for ways to make more money in a shorter span of time, an idea (not so) faintly reminiscent of the good old get-rich-quick scheme.
Of course, who would your broker be if he couldn’t read your every wish from your lips. They are very aware of people’s proclivity to cut corners and their desire to make money without working too hard.
Enter margin trading and leveraged derivatives.
Derivatives are not assets, they are virtually binding agreements, i.e. contracts, between two parties. Instead of buying an asset such as a stock, you are entering a bet with someone on what that stock will do in the future.
Because derivatives are contracts, whatever they include is up to the signing parties. That introduces the idea of leverage, i.e. writing a contract that is not linked to single share of a stock, but to the movement of the stock itself. Thus, a derivative contract can contain any amount of money, and financially amplify the implications of the stock moving in any direction to almost any degree – all depending on the terms of the contract. Hence the term leverage. For example, a single unit of the popular ‘option’ contract controls 100 shares of stock by default.
You do not need to own the total amount of money at the moment the agreement is drawn up (only when it is “called in”) and only a small amount. That is because most brokers will eagerly loan you money so you can also make such contracts with larger unit sizes than what you could pay for currently by yourself.
If you want to own stock outright, your broker will borrow you money – as long as you have some already in your account, known as ‘margin’.
A broker is loaning you, a total stranger, tens, hundreds of thousands, if not millions of dollar to trade. How self-less and altruistic of the broker … Or is it?
When you take money loans from the broker to trade stocks or derivatives, you control more capital. Remember from above that amateurs will get disillusioned by the small haphazard profits their small accounts generate without a strategy, and will try to cut corners – for example by trading large by borrowing money. Most amateurs, driven by impulsiveness and lack of strategy statistically trade more often and larger sizes when offered to use margin or derivatives.
That is not a trivial effect by the way – the average retail amateur, once opening their account, plunges right in to trade day in and out, and within a month or two starts using the heavy leverage that is being generously offered.
Remember that every trade generates commissions and execution spreads. High turnover produces more of each (read below how people are incentivized to trade more often), and trading larger (i.e. with borrowed money) opens up another venue of income – margin loan interest.
Passing the buck – The “Financing Turn”
Ask yourself – where do the exorbitant amounts of capital necessary for loaning thousands of customers substantial margin come from?
Why, banks, of course.
A broker goes to the bank, puts up some collateral, and gets a revolving credit facility of a few hundred million dollars – and he will have to pay interest on that loan, of course. When the broker gladly borrows you part of this money, he will do it for a wee bit of interest of course … a wee bit of interest more than he is charged by the bank.
Say, the bank charges the broker an annualized x% on the bank loan – then, you’ll be charged an annualized x+1% for you borrowing the same money. This is not a lot if it’s just one customer, but it’s millions accruing for the total business when accumulating over time and their whole client base.
A broker doesn’t just outsource their bank loan interest payments to you, they make a +1% profit on them – they take a “turn” in the financing of your risk.
Fret not – it gets worse.
Because, as you know, every loan requires collateral. What is the collateral that the broker uses to get these wads of cash? Why, your and other clients’ deposited trading capital of course.
In essence, your money is used as collateral for the broker to borrow more money and loan it back to you at an even higher interest, while technically, as the collateral holder, you assume the third-party financing risk.
A great deal … for the broker.
Products that work against the client
Though there are many Pros out there making money with derivatives and margin loans consistently, anything involving borrowed money is a bad bet for an amateur in the stock market. That is because leverage goes both ways, and the allure to escalate leverage to suicidal scale in a get-rich quick expectation after having tasted a little blood is so large that most amateurs blow up.
For margin trading, if the stock goes up, good on you – you will make the more money the more you borrowed. But God have mercy on you and your risk management skills when it’s the other way around – you can lose more money than you traded with if you don’ act appropriately.
I’m not a huge Warren Buffett fan, but when it comes to derivatives and their usage by amateurs he is dead right, once calling them “financial weapons of mass destruction.”
You will have heard of some of these derivatives – options contracts, the main instrument of self-destruction in the US but also heavily traded all around the globe, or the lately prominent CFDs (contracts for difference) and more exotic options types used to (no) avail mainly in the EU and parts of Asia.
With a stock, many people can buy and sell the same stock to each other at the same time and all make money – a non-zero sum game.
With a derivative, for every contract, someone takes the other side – for every winner there must be a loser – a zero-sum game.
And the involved leverage introduces volatility that does not exist in the real market, amplifying potential for losses. This can go quickly to the point where you are called by your broker to either put up more collateral or they exit the contract for you – the notorious margin call. Congrats, your account is blowing up. In extreme situations, extreme volatility can cause a negative balance – you now owe the broker money.
For buying the widely-popular options contracts, time decay is the worst killer. Many amateurs get frustrated by this and start writing options (i.e. taking the other side of the contract) instead. This however is highly capital intensive (that’s why investment houses, smart pros and brokers only do it), so they then proceed to write what’s called a naked option, i.e. selling someone the right to buy from them or sell to them the stock in the future, while actually not even owning the underlying stock.
That usually goes well 9/10 cases – but in the tenth, a stock gaps up or down wildly on a a weak market, news, a company takeover or an FDA rejection, the trader blows up, and owns the broker money.
This happens all the time – but the broker still always gets their money in the end.
As for CFDs that are so popular in Europe & Asia – they are banned in many jurisdictions, among them the US, Belgium or Hong Kong. Why do you think that is?
As an amateur, stay away from any leveraged derivative, or margin trading at all – this is reserved for those that have experience and know how to deal with the extreme double-edge sword dynamic of margin – the leverage can work against you as much as it can for you.
If you know that you are doing, never get into extreme amounts of leverage (1.3-2x max. margin in the absolute best market environments) and get off immediately if the market is showing signs of turning. Chose your commitments so that margin interest will never be more than an extremely minuscule fraction of your profits gained from using margin.
If a position goes against you, never answer a margin call. Never throw good money after bad one. You were wrong, and burning more money is not gonna make you right. Take the loss, even if it is gigantic, and learn from your mistake.
For derivatives, we also have to remember the other side – as for guns, derivatives don’t kill accounts, people and their lack of risk management do. They can work, if you know what you’re doing
#4: Taking the other side – “Fading” the client
Now to the worst and most lucrative – betting against the client.
You will have seen a disclaimer at the bottom of certain brokerage websites, which are required by law in many countries: “xx%of retail investor accounts lose money when trading with this provider”, or similar.
That’s not there by mistake … and these xx% includes people just like you.
There is a general rule in the stock market – about 90% of those actively selecting stocks/derivatives/etc., plus minus, lose money consistently. This goes so far that there is the infamous 90/90/90 rule – 90% of traders lose 90% of their money within 90 days of starting to trade, on average.
Well, if you have someone with a 90% chance of losing, and turn this equation around, you get a 90% chance of winning if you take the other side. The broker knows exactly who is winning or losing, as they can see their clients track record.
Thus, when the 90% that lose money consistently buy a stock, the broker may short the stock and hedge the bet (e.g. via derivatives) – resulting in a 90% chance of a winning position, and at worst a hedged flat position or a minimal loss.
Some brokers don’t even hedge – these odds are just too good to waste money on insurance. It’s difficult to grasp just how outlandish a 90% win chance is in the market.
Nowadays, this is all done automatically & electronically, and happens up to thousands of times per second (depending on the brokerage size).
It happens with stock itself, but specifically with derivative contracts traded over-the-counter. Over-the-counter (OTC) derivatives are not cleared by investment banks. They are not routed to the exchanges but are written out to you by the broker or another actor from a non-exchange broker-dealer network.
This can easily done with the popular options contract, which can either be routed to the exchanges, but also into a broker-dealer network or be internalized, i.e. the broker directly issues you the derivative contract, betting against you.
OTC dealing, i.e. internalization or broker-dealer network routing, is the bread and butter of CFD contracts – remember, every contract needs a counterparty to bet against you, and the broker will be more than happy to take this burden.
The appearance of CFD- & spread-betting platforms can be compared to the notorious “bucket shops” of the early 20th century that Edwin Lefèvre chronicled in his timeless ‘Reminiscences of a Stock Operator‘. In essence they reflect the same idea – give the clients high leverage, and bet against their low-probability ideas.
But options aren’t too far off. They can be another almost no-risk money printer for the brokerage industry. The broker may not only make commissions/spreads on orders but may also internalize the orders i.e. write/issue the option themselves to collect the premium. Since they do not need to write naked options, and have a 85-95% chance of the options either expiring worthless or the position being closed out before that and the option covered by the broker, what’s not to like?
Of course, they’ll use part of the money they borrowed from the bank using your money as collateral to make the bets against you larger.
Stay away from OTC-only brokers, which are usually CFD-only brokers in non-US countries. They often imply on the website that you’ll be buying and owning actual stocks through their service, but actually you end up holding a bunch of CFDs, so always read the fine print and disclaimers.
Similarly goes for other exotic brokerages, such spread betting brokers (directional contract bets), and zero-cost brokers that offer no explanation how they make money.
#5: Getting the avalanche rolling
Of course, instead of letting clients haphazardly finding and developing profitable strategies, it’s in the brokers interest to keep them in the dark to encourage consistent over-trading.
To do so, they will shower you with free education, newsletters, tips and “expert” knowledge from their in-house masters of the market – all so you can eventually learn how to become profitable. But not really.
It’s a massive industry.
Brokers and their partners teach and incentivize you to trade as frequently, large and margined as possible, always pushing on short term ideas that require frequent buying and selling orders. This includes educational campaigns and partnerships with educators to push you towards technical day-trading strategies and avoiding overnight risk, chasing regular income generation, etc. towards more and larger trades by desperate people trying to grow their income
They always dangle the next shiny idea in front of your eyes, day in, day out, irrespective of whether the last one worked. That is because there is always a new guy on the hunt for the big quick money. The broker knows about this impulse, and hunts that guy down based on it.
Remember, every order means commissions, spreads, and the potential to get margin loan interest and to fade clients. That means turnover is key for staying profitable.
The dominant premise is – a broker wants you to trade as often and as large as possible, to make your money wander into their pocket, like a slow-drip. You are incentivized to do so to generate them a profit, and many a broker will penalize you not doing so with inactivity fees and minimum deposits.
This gets worse with “social trading” platforms. You know them – the ones where you “follow” and automatically “mirror” a profitable trader … one whom you’ve never heard about but everybody seems to be happy with. Problem is, these platforms have an unbelievably high number of bots or “stochastic” winners (think ‘even the blind hen wins a series of trades sometimes’) that are sold to you as the new generation of Paul Tudor Jones’es.
Every time the “leader account” goes up randomly by a couple of percent all the “follower accounts” churn out orders like crazy to generate commissions.
Of course, it gets worse – Some of these platforms are in reality only fronts for the same brokerages.
Skepticism will keep you alive
Not all of these “profit centers” are publicly known, but there should be hints in the 150,000-page small print contract that you sign when you open your account. There’ll also be a risk disclaimer in there which tells you all you need to know about this shady business – in essence, it states that you’re OK with losing everything and it definitely will NOT be the broker’s fault.
The whole liquidity supply chain, from the exchanges to the investment banks to the brokers, requires the “dumb money” to profit. Dumb money though is not always private individuals /retailers; it can be large funds that just don’t know what they’re doing.
However, brokers are and will remain a necessary evil. For the moment, we still do need someone to facilitate our orders – to find us a buyer or seller for our shares … at least until one day trustworthy decentralized dealing networks will come along, e.g. via Blockchain technology.
By no means though do we have to make it so easy for them.
As I said above – the main benefit of this article comes from understanding the brokerage business model, and counteracting it with having a profitable strategy. Choose a broker, and make large money with few orders.
Despite all the free advice, newsletters, daily “best stock picks” and so on that you will get into your inbox by them – your broker is not your friend. You should seek your own education, and certainly not design a trading strategy that is based on what the broker tells you to do.
Become a profitable stock speculator – you’ll be the worst client to a broker. Learn here how.
