Do you know what the most annoying part of investing is? You watch a stock, it’s growing, and it looks like it will never fall. You do your technical or whatever analysis, and everything indicates that the stock will keep rising. That moment when you decide to buy the stock, it crashes. It starts falling. You might not have realized that, but the moment you actually spend your money and buy a stock, you will pay attention to that.
It might rise back, but quite often, the moment you purchase the stock, it instantly starts going down.
Have you ever wondered why?
The obvious answer is – the market. That’s how the market is. You can’t do anything about it. The laws of demand and supply determine the price of the stock, so if the stock is falling. It’s because more people are selling the stock than buying.
Technically that’s true, but quite often, that’s not the case. It is a bit more complicated than that. What if I told you that the market is designed in such a way that no matter what stock you buy, it will most likely fall the moment you buy it? When you want to buy a stock, you will most likely pull up your phone and do it through an online broker like Robinhood, TD Ameritrade, Webull, or any other broker.
You can’t directly get into the market and purchase stocks from companies since everything is done electronically, and most stocks are sold on the secondary market.
But what if you are a huge investor? What do you do?
Let’s say you are a huge investment, and you want to buy 1 million tesla stocks at $720. If you put that big of an order into the market, everyone is going to notice that, and they will also buy tesla stock, hoping to profit from the stock spike, driving the price higher. So, you will not get all your stocks at $720. Or vice versa.
What if you want to sell 1 million tesla shares at a specific price? That’s going to drive the price down. So to make sure that you get the best possible price, you are not going to directly buy that many stocks but call a financial institution to help you with that, such as Goldman sacks or JP morgan.
JP Morgan is going to contact other investors and collect sell orders to get 1 million tesla shares at the best possible price, which, let’s say, is $720. And that’s called a dark pool which is not regulated and is not accountable. But sooner or later, the transaction is going to appear on the open stock exchange when it happens. And the stock will spike.
However, the big investor has already purchased a million stocks. Dark pools are specifically designed for such purposes. Dark pools are much more common than you think. According to the CFA Institute, non-exchange trading has recently become more popular in the U.S. Estimates show that it accounted for approximately 40% of all U.S. stock trades in 2017, compared with an estimated 16% in 2010.
Who else uses dark pools?
Exactly! Robinhood! where most retail investors who are reading this article buy stocks. You can make a case that there is nothing inherently bad with the fact that Robinhood uses the dark pool, and you would be 100 percent right, but things are not as simple as they might appear at first glance.
Since Dark pools are private exchanges for trading securities that are not accessible by the investing public, we don’t know everything that’s happening behind the scenes, but what we do know for sure is that a vast part of Robinhood’s revenue comes from selling your trades to hedge funds.
Since the invention of the stock market, hedge funds, investment banks, and institutional investors have tried to come up with different ways to predict the market. Once you know which stock is going to rise, you have a guaranteed way to make money. Just buy that stock, wait till it spikes and sell it, and boom, you have made money. It’s as simple as that! And vice versa.
if you know that a stock is going to plummet. All that’s left for you to do is to short it. That’s why inside trading is banned because inside trading gives you an advantage over the market. You know for sure which stocks are going to rise and which ones will fall.
However, Robinhood has revolutionized the industry. When you buy a stock through Robinhood, you are not buying it directly from the open exchange but rather through Robinhood’s dark pool, and then it will appear on the stock exchange once Robinhood sends your trades to the open exchange. However, before sending them to the open exchange, your trades are sent to hedge funds.
So Hedge funds technically know which stocks are going to rise. Let’s say there are thousands, if not hundreds of thousands of purchase orders on Apple stock from different investors on Robinhood. It will slightly push the stock to spike, at least. So hedge funds would also buy apple stocks right before it appears on the open stock exchange and instantly sell it when the stock spikes.
These all happen in a fraction of a second; it’s called high-frequency trading. It’s a trading method that uses powerful computer programs to transact a large number of orders in fractions of a second. It uses complex algorithms to analyze multiple markets and execute orders based on market conditions.
In plain English, Robinhood sells your trades to hedge funds, which use these data to buy stocks before it appears on the open exchange and then sell them the next moment bringing the stock down again because hedge funds are the ones who are actually making a profit from this deal.
Of course, individual trades don’t make much of a difference, but Robinhood has over 22 million users. Collectively their trades can move the market. And secondly, hedges don’t make astronomical returns on these high-frequency trades. Margins are slow. It could be from a few cents to a few dollars. But when you combine them together over time, they turn into hundreds of millions of dollars, if not billions.
Over 50 percent of Robinhood’s revenue comes from selling users’ trades. That’s how Robinhood manages to keep its platform free. As a wise man once said, if the product is free, then you are most likely the product. Robinhood has already been sued for its shady practices. Instagram, Facebook, and Google are free, but your date is sold to advertisers.
We can criticize Robinhood as much as we want, but there are really no alternative options. Webull, Ameritrade, and other brokers also sell their user’s trades. So, you are left with no other option but to accept the harsh reality. However, if you are a long-term investor, you shouldn’t care about such things since what you care about is where the stock would be a year from now or longer and not a few minutes or seconds, or milliseconds later.
Does that mean there is no point in trading since we have supercomputers that also have access to information that you and I don’t have? The answer is yes and no. There is still money to be made even if you are a retail investor, but you should keep in mind that you are always behind the hedge funds.
Hedge funds pay premiums to brokers such as Robinhood to access that kind of data. Of course, this is not the only reason why stock prices fall right after you buy them. There are many more reasons since the number of factors that influences the price of any stock are beyond what we can discuss in a single article, but the fact that most retail investors use brokers such as Robinhood is one of the main reasons.
What do you think about Robinhood’s business model? Do you think they have the moral right to sell your trades in exchange for keeping the platform free? Let me know in the comments below. That’s it for today. Thanks for reading.
Disclaimer: This article’s information should not be construed or relied on as legal advice for any specific fact or circumstance. This article is intended solely for entertainment and information. Reading this article does not establish an attorney-client relationship between you and 180 Law Co. LLC or any of its attorneys. You should not act or rely on any of the information contained in this document without first seeking professional legal advice.