They sell orders/trading data of small retail investors to Big High Frequency Traders so that they can gain an edge in the zero sum game of day trading. 'Robinhood' seems like an apt name.
In my experience, if you stick to highly liquid stocks/options (SPY for example) the bid/ask is a penny and you don’t experience much slippage, less liquid stocks you can end up getting a worse price (0.01-0.02, in my experience)
The amount of capital I actively trade with makes Robinhood a good fit for me, the amount of contracts/shares I trade in an average position would need to gain 1-2% more to get the same profit if I was paying fees (particularly on options)
I have heard from the horse's mouth that small retail investors orders/trading data is used as a contrarian signal. In other words the Big Traders see what the small retail investors are doing, and do the opposite.
Assume you are a market maker - you make money off of the bid-ask spread. Specifically, you supply liquidity by issuing standing orders: To buy at the bid, and sell at the ask.
For a market maker, you typically want the price to "stable", and you set your bid/ask to reflect the current order flow supply/demand - this is the "equilibrium" price.
When prices are volatile, your risk is greater. Typically, market makers have to maintain some position in the securities they transact in, and if they don't effectively hedge this position and the price moves against them, they could take big losses.
The optimal condition for a market maker is to have supply and demand balanced, and unchanging. Then you can simply make money off the bid-ask spread without much risk. (All else being equal, having fast access, i.e. HFT, and fast processing systems to detect upcoming likely prices changes also helps)
Market makers are worried about adverse selection; that is, if a huge buy order comes into them, they are worried that the buyer knows more about the price of the security than they do. If they sell to them, the price could subsequently increase, and they could take a loss. (The same applies for a big sell order)
That is why they would prefer not to transact on the open market - i.e. the exchange. It's difficult to tell who are the informed traders.
Instead, they would rather transact against "uninformed" traders. "Uninformed" here does not imply "stupid", but rather just implies that, on average, these traders don't possess any special information or any more information than they do.
In the optimal sense, market makers would prefer to transact against an order flow that is unbiased; one example of this would be an order flow where there are equal numbers of buy and sell orders.
This is why market making firms pay for retail order flow. Retail order flow is assumed to be uninformed, and therefore unbiased relative to the information that the market makers themselves have. Being able to transact against retail order flow thus gives them a relatively unbiased order flow from which they can profit off of the bid-ask spread with much lower risk.
None of the market makers as far as I know consider retail orders to carry any information at all, which is precisely why they love then so much.
They can fill retail orders with no real concern about adverse selection (unlike on an exchange where an informed institution is trading against you) and make much more of the spread per trade. Hence why they pay for the orders and give price improvement
