It's not surprising that Robinhood gets paid the most PFOF per order of anyone in the industry - if you know what market makers need to succeed. A thread:pic.twitter.com/EnOdRCxasi
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Imagine you're a market maker. You make $ on the bid/ask spread - giving liquidity to traders by buying low & selling high millions of times per day. As long as you can identify profitable trades, the more volume you get the better.
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In exchange for skimming $ from the spread, you take on some risk of the market moving against you. If an illiquid stock tanks while you're making a market for it, you end up buying a falling stock with no one to sell it to. That's a no no.
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You're a good market maker. You know how to avoid being a bag-holder. You stick to large-cap, liquid markets to help reduce the risk that no one shows up to offload your inventory.
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Your margins get so good that you're willing to pay brokers to give you trades that fit your strategy. Instead of drumming up interest in your market yourself, you give some $ to brokers to do it for you. That’s payment for order flow (PFOF).
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If you do venture out to less liquid markets (like options) you need traders that won't run away at the first sign of trouble. You need traders that aren't watching the order book for market imbalances. You need bag-holders.
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Enter Robinhood. Their clientele is almost exclusively the bag-holder type, enticed into trading with free stock, confetti, and dopamine hits. If you made a market for these trades, you could buy lower & sell higher with less fear that they'll run away.
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That is why Robinhood gets the best PFOF rates. Their retail order flow is the least risky, and MMs can make higher margins on it. With higher margins comes more willingness to pay for the privilege of taking orders. Fin
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Can you explain “skimming money from the trade”? How much on average can they skim from the different asset classes eg options versus straight equities. Maybe a super simple example with numbers? Thanks!
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Sure - these charts show hypothetical markets for a stock and an option. MMs make $ by buying the bid and selling the ask. The stock is very liquid, so the spread bw the bid & ask is tight. The option is less liquid so bid/ask can vary widely. More risk = more space for profitpic.twitter.com/F1SLCpCw4m
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