The Capital
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The Capital

No free lunches in trading either

What payment for orderflow is and how it can hurt retail traders

Payment for Orderflow

Naive as I can be, I had assumed that a lot of trading on Robinhood or similar brokers would be traders trading with each other. A peer-to-peer kind of platform with the occasional market maker, ensuring liquidity inserted.

  • Market makers: as they compete, every order increasing liquidity counts and increases the probability of executing an order most optimally.
  • Exchanges: by paying for order flowing to their exchange, they can increase liquidity and promote themselves better.
  • Other institutions might also pay for order flow to bundle large block orders, which allows them to fill their own orders without outsourcing them to liquidity providers. In the case of the GameStop frenzy, it turned out that Citadel Capital, a hedgefund losing big time with it’s Gamestop shorts, was paying for order flow on Robinhood. This sparked a lot of debate and outrage when Robinhood shut down its platform for the average trader.
  • Trading against the retail order: this is somewhat what happened with Gamestop, but this time the retail traders were trading against the hedge fund. Firms paying for orderflow can use the incoming orders to short against them, fill the retail order, and then drop their ask price to trigger a price decrease, allowing them to cover orders from panic-sellers at lower levels. And panic-selling the little guys will, as most of them can’t afford to lose too much. Please note, both scenarios only work out with limit orders.
  • Market Orders are most profitable for the trading companies paying for orderflow. They can capitalize on the spread while benefitting by further sending those orders to dark pools and alternative trading systems, paying them for orderflow.
  • As outlined above, trading firms can trade against retail orders. It’s quite common that long orders are filled just before the price drops. This fuels the impression of traders that prices will drop as soon as they’ve entered the market. Unfortunately, FOMO often gets the best of us, and we end up buying at the top.
We’ve all been there…



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Naomi Oba

Writer in Crypto — passionate about financial education, blockchain, books, and food.