What is Robinhood
Robinhood is a no fees, no fuss app designed to help the millennial invest. The company has exploded since its creation in 2014, and many are wondering if it deserves all of the hype.
In this article, we will have a good look at the RobinHood app and answer the following questions:
- How does the Robinhood App work?
- How does Robinhood make money?
- What you need to know before using RobinHood, or any other basic trading application.
How the App Works
Robinhood is a mobile and smartphone app that makes buying and selling stocks very easy. One of the major bonuses is that the bare bones RobinHood app does not have any transaction fees; real savings as typically, brokers charge between $1-7 for each transaction.
The app has the major advantages of being totally free, very easy to use, and you can automate your buys and sells, so you don’t even need to obsessively watch your assets.
However, the basic app is very basic and only allows you to buy or sell stocks. With this app, you cannot short sell, trade mutual funds, options, or used fixed income instruments. There is a reason that this is a no-fees app.
Data and Research
The Robinhood app is free because it is basic, there really are no bells or whistles here. The app does not offer you the guidance or insight that a brokerage firm will, which is the main argument for paying for your transactions with a brokerage. A brokerage is meant to help you make smart investment decisions by offering advice and important trading data.
This app does not offer any of its own market research, news, chart analysis or educational resources. The app simply facilitates your investment buys and sells, but does not do anything else.
Buying on Margin
One limitation of the simplicity of RobinHood is that it does not seek out price improvements for you. You can set you automated buys and sells for the stocks you are watching; so if you want to sell stock Z when it reaches $50, that is no problem.
However, because the Robinhood engine is not watching for price improvements, it is possible that you will miss out on the best time to buy.
Also, seeking out better price improvements may not make much of a difference when you are buying in low quantity, say 50 shares. But as soon as you want to buy in 300 or more shares, a dollar or even $0.50, will make a serious difference; that’s $150 difference in this example.
Because of this you either need to really be on top of price changes and work with your app to do so.
But, if your needs are more modest, as you are a new investor, this may not affect you quite as much.
Initial Funds and Meteoric Rise in Users
The major benefit to RobinHood is that they have built an app that makes stock trading cheap, is intuitive and is mobile. These are all things those who are new to investing find very appealing.
When Robinhood started out, they were invite-only. But once they had opened the app to the public in March 2015, there were over 700,000 on the waitlist. TechCrunch reported that by November 2015 it had facilitated over $1 billion in transactions.
RobinHood is a classic example of overnight success and demonstrates the market demand for accessible trading applications.
By 2018 RobinHood’s users had doubled from 2017. They also completed a Series D funding round of $363 million, which brings it to its current valuation. Currently, Robinhood says that it has 4 million users.
Recently RobinHood has expanded into 16 popular cryptocurrencies, including Bitcoin, Ethereum, and Litecoin. The expansion of their easy online trading app to cryptocurrencies may have a lot to do with the recent success of the app.
Free lunches: How is Free-trading Making Money?
With all of the success that RobinHood has had offering free-transactions, many wonder how the company makes money at all. And the bottom line is that because they are not a public company, this information is hard to verify.
In a statement issued by Vlad Tenev, the firm’s co-CEO and co-founder, on October 12, 2018, Robinhood claims that they receive very little income from payment for order flow. Robinhood earns around $0.00026 in rebates per dollar traded or 2.6 cents per $100 traded, Tenev states.
Another reason that RobinHood is unlike most brokers, is that they do not regularly release reports for payment for order flow on a per-share basis. Without this information, it is difficult to accurately compare them to how other brokers are making money.
In September 2018, Logan Kane, a contributor to Seeking Alpha, stated that:
Robinhood’s payment for order flow generated ten times the revenue as other brokers receive from market makers for the same volume.
Based on a Bloomberg analysis, Robinhood’s reports to the Securities and Exchange Commission (SEC) calculates that they generate nearly half of their income from payment for order flow.
Read the Fine Print
Not everyone is a supporter of Robinhood’s trading app, basically because it seems too good to be true. While there is nothing inherently sinister about offering free services for users, it does make one wonder how they are making money.
Users do not pay any transaction fees, but there are other costs they can incur. Robinhood passes through any regulatory fees that are incurred when a trade is placed. The price of such fees are typically fractions of a penny, still, they round those fees to the nearest penny.
Robinhood also charges $10 per transaction made on the phone with the aid of a live broker, and foreign stock transactions cost between $35-$50.
Another interesting piece of intel from Logan Kane, a contributor to Seeking Alpha, stated that Robinhood’s payment for order flow generated ten times that of the revenue of brokers receive dealing with the same volume.
By Bloomberg’s analysis, Robinhood’s reports to the Securities and Exchange Commission (SEC) calculates that they generate almost half of its income from payment for order flow.
Another reason that some think Robinhood is too good to be true is their lack of transparency. It is also important to note that payment for order flow is slowly being regulated out of existence. That means that those brokerages that depend on generating income by selling order flow to market makers will face serious troubles within five years.
It’s important to remember that Robinhood is a business, they are not a charity. There is nothing wrong with that! It just means that they need to pay their bills as well, and so the creators are not acting out of the kindness of their hearts.
With that in mind, it is important to remember to read the fine print and make sure you understand where you are putting your investments.
Gold Members and Buying on Margin
One way that Robinhood is making money with free transactions is by earning interest. Robinhood earns a large part of their interest by allowing Gold members to buy on margins.
Buying on margin is a standard loan that most online brokers offer. This allows customers to borrow money in order to make larger purchases.
For Robinhood Gold, the account minimum is $2,000, which is a regulatory requirement required by all brokers. Members also pay a monthly fee for access to a set amount of margin loans.
So, just to hold the membership and to have access to an additional $1000, members pay $6/month. The way that margins work is that the more cash you hold in your account, the more you are able to borrow. Your margin is approximately 50% of your balance. The interest rate is 5% if your account is large enough to qualify for more than $50,000 of margin.
Gold customers also get to use funds early, that is before the 2 to 3 business days that it takes for the transaction to be completed. The maximum is based on one’s individual membership status.
Investopedia has worked the approximate interest earned by RobinHood out to be 7.2%. This is low compared to TD Ameritrade or E*Trade, however high when compared to Interactive Brokers.
Robinhood has tapped into a niche with millennials who would rather use apps then fuss with other tools. And they could not be offering their services at a better price of $0. Other apps have tried to follow their examples, such as Divvy and Clink. Despite the competition, Robinhood still has these other apps beat, one good reason is that they do no have the same venture capital as Robinhood does.
Like most financial products, brokerages, and banks, Robinhood makes money with an interest income. The money you hold in your account unspent is lent out to back other projects. The Robinhood website explains:
We generate money from Interest from customer cash and stocks, much like a bank collects interest on cash deposits.
This is a completely common practice, and your bank does the same things as well. The reason you can have a free checking account is not due to the generosity of your bank. By holding funds with the bank they can then use your cash to lend to others and those loans earn interest.
(This is why it is always bad when everyone pulls their cash out at the same time. Cash-dashes have occurred throughout history and typically results in an economic meltdown. The world functions on loans and interest.)
Your bank, your credit cards, your student loans, these are all examples of institutions earning money off of interest, and Robinhood does the same. By encouraging users with $0 transactions, they have been very successful in accumulating a cash flow.
Robinhood does not earn money through lending interest, rather they earn interest with margin trades, bonds, and savings accounts. For example, if Robinhood makes only $10 off of every $500 cash balance, and they have over 6 million users, the zeros line up quickly.
A couple of things to think about however are: Firstly, unlike a savings account or brokerage, users are not earning interest with Robinhood, but by earning interest, Robinhood can offer free services.
Secondly, exactly what Robinhood is worth is not public knowledge, as I stated earlier, as they are not a public company. So it is really unclear how much cash Robinhood is holding, and what the precise value of the company is.
Earning Money on Money
Robinhood also makes money on high-frequency trading and order flow. Based on a report from CNBC, Robinhood’s order flow revenue increased by 227% in 2018.
That means that in 2018 the company brought in $69 million with high-frequency trading and overflow alone. This is likely the result of amassing so many users over the last four years.
Robinhood’s website states:
When you buy or sell stocks on Robinhood, like many other brokerages, we send your orders to market makers that allow you to receive better execution quality and better prices. Additionally, the revenue we receive from these rebates helps us cover the costs of operating our business and allows us to offer you commission-free trading.
Brokers v. Apps
Traditionally, there are basically two kinds of brokers: discount brokers and full-service brokers.
Discount brokers are much less expensive because all they do is execute trades for the investor. They charge only about $5-15 per transaction, but they do not offer any advice.
Full-service brokers provide more services, such as money managers and financial planners. These are people who are informed about the markets and thus are well paid to provide you advice. Such firms and brokers are going to charge much more, and they will also make commissions off of your investments.
Full-service has some obvious benefits. For instance, investors get intelligent advice from people who know the markets and have access to quality data. They will also have a better idea of what to buy, when to buy it, and will be able to buy on the margin.
The down-side to all of these fancy tools and expensive advice -is that it is expensive. Not only are you paying per transaction, commission fees and who knows what else. Investors often must start with a minimum balance or buy-in that can be very high.
This means that investing is inaccessible for many. So even a basic app like Robinhood that just facilitates trades is beneficial because you can actually get your investments started, as there are no mandatory fees or minimums for straight forward sales or purchases of assets.
What You Need to Know Before Using a Trading App
Here are a few things to consider if you are planning to go solo and invest using an app like Robinhood:
All of these are strategies or orders, investors use so that they can buy a stock at the price that they want. That means, using these strategies your stocks are not purchased in real-time. Instead, the shares of the asset are only acquired if and only if the asset you want reaches your desired price point.
Using orders to budget your investments is a smart and easy way to manage your investments.
Especially if you are a new investor with not much cash to spare, Robinhood’s orders are smart and feasible tools to use with an app. Using a limit order, for example, you will not spend more than you can afford on the shares you are watching.
#2: Keep a cash balance in your trading account.
With Robinhood, you can keep money in your account so that you are ready to get a hold of the stocks you are after quickly. If you keep money in your account you can take advantage of Robinhood-instant, which allows you to make a purchase right away. This is helpful if you are using a limit order to buy, because then once stock B, reaches your desired price the purchase will go through right away.
Also, it is important to remember there is a lag time between your cash deposits and their availability. It takes up to 3 business days for the money to be available in your Robinhood account once it is transferred from your bank account. And if you do not have the cash ready to make the purchase, you could miss out on the stocks you are watching.
#3. Use automation for your mental and material health.
Set your buys and sells to automate the majority of your purchases. Robinhood allows you to use automation so that you catch the prices you want on the assets you want to invest in.
Automation is not only easier, but it is also smarter and makes investing feel less stressful. It is easy to get swept away by the movement in the market; but that is the nature of the market. Sometimes your stock is up and sometimes it is down.
Automated buys will also help you to keep peace of mind. If you use automated purchases then not only are you not going to miss out on the prices you want, but you don’t have to constantly check your gains or your loses -and you will have both!
#4. Get to know market fluctuation.
The markets change every day. This is why it is important to have automated purchases so that you don’t miss out on the assets you are watching. But it also means that the value of your assets will go up and down. Don’t panic and ditch your assets when you see a drop.
This also means that it might not be the best idea to check your assets daily. Watch the markets, do your research so that you are making solid investments. But you could give yourself a stomach ulcer if you watch every dip in your market.
Try setting 2 or 3 days a month when you check on your assets after you have done some research and market analytics. Some stocks will recover, but it is also good to ditch the dead weight.
#5: Do your research.
Robinhood does not offer a lot of quality long-term or short-term analytics, this is one of the reasons that the app is free. But that does not mean you don’t need to do your own research. Market research is a must so that you can make sound investment indecisions.
Taking the Leap
Simple trading apps like Robinhood are a great way to get your feet wet if you are new to investing.
If you are a seasoned trader, then this app is likely too simple for you, and maybe you even want to start building your own trading bot.
The greatest win with FinTech is that apps like Robinhood are making wealth accessible for many people that it was previously impossible for. Building your investment portfolio is possible so long as you have a smartphone and some data.
As I mentioned, if you are working with a broker, you likely are not dealing with small potatoes. But most of us are small potatoes, so there is no harm in educating yourself and giving it a try!
Here are 3 good reasons to start investing:
- Practice makes perfect. Start small and simple, and with time and patience, your assets will grow. The sooner you start the more time you have to learn how the market works. The longer you wait the closer you get to an impoverished retirement.
- Once you’ve made a little money, hold on to it! Compound interest is the investor’s dream we all hold in our hearts -the more money you have the more you earn just by having it.
- Develop a healthy relationship with your finances. Finances and investing are not intuitive, you need to put in the time to figure out how the system works. Once you have started the new habit of wise saving and investing, it will get a lot easier and maybe even start to feel intuitive.