What is copy trading?

Joining the 20% Club.

It’s a very well-known adage in the trading sphere that ‘80% of traders lose’. While this is a relatively crude figure, conveniently rounded and clearly more of a sound-bite than derived from specific research it is one that is more accurate than it is inaccurate.

But on its own it paints a slightly misleading impression. Sure, it gives a clear suggestion that trading is harder than many would have you believe and implies that the more you work on your trading the more you shift the odds in your favour. However, it does give the idea, at first glance, that there is this 20% of traders sitting out there making constant returns. That’s the bit that we need to look at and consider.

Is it the same 20% of traders always making positive returns? Is there some elite group that with enough hard work and dedication you can become a member of? That really doesn’t sound all that realistic. In reality, it would be more accurate to say that at any given time in the market around 20% of traders are making money. That seems much more plausible. Out of that 20% some will be the crazy gamblers who are on a roll until they next blow their account up and at the other end of the scale some of that 20% will be thoughtful, experienced traders who are managing their risk and trading in a highly competent manner. At the same time, some of those good traders will be finding the market conditions not to their suiting and will be going through a period of not making positive returns.

If we accept this then being able to see who is in this ‘20% club’ at a specific moment in time suddenly has enormous ramifications to a trader whether they are a good trader, a bad trader, on a roll with the markets or going through a draw-down phase. Knowing who is making positive returns, who is in this ‘20% Club’ is hugely interesting on its own but add being able to see what they are currently doing, live and what they have been doing in the past is huge. Absolutely huge.

This is where one of the single largest evolutions of the trading industry in the last decade has taken many traders.

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Social Trading or Copy Trading?

There are two main products that have come to the market in recent years, Copy Trading and Social Trading. The terms are very often mixed together and one used to describe the other but they are two differing products in reality.

The concept of Social Trading has been driven by the arrival of social media, hence the name. In its simplest form it argues that you can run algorithms over social media content such as financial bulletin boards, Twitter and Facebook to determine the consensus view of the masses and that this consensus view is going to be the correct view and thus produce profitable trade predications. Over the years we’ve seen many such products brought to market and quietly disappear after a huge fanfare of Silicon Valley style excitement.

For starters, no algorithm has ever been written that can cope with British sarcasm and cynicism. We might read a Tweet that simply says ‘This stock is awesome’ and while the algo stores that as a positive sentiment we appreciate instantly that the poster is being sarcastic.

Anyone who has ever spent any time frequenting financial bulletin boards also knows that much of the positive hype following any specific story is usually just the masses regurgitating the same things in the blind hope that it will push a market up. Illiquid penny shares maybe? Global markets? No.

Brokers entered the social trading sphere with heat maps that displayed what the most popular markets were and which way their clients were trading them. But these never really grabbed attention because you never really knew how this data was derived, how weightings were taken into account. Was it displaying the number of trades or the size of those trades and which clients? If we know that 80% of clients are losing at any one time then what’s this information really telling us?

And the final nail in the coffin of Social Trading has probably been the realisation that so much news on social media as well as mainstream media is fabricated and the arrival of ‘Fake News’ into our everyday parlance

Then we have Copy Trading. In its purest form Copy Trading is just pure, live data. You aren’t looking to analyse any consensus views or seek out some collective that secretly drives the market, you are just looking at real traders making real trades and making a decision as to whether to follow/copy one or more of those traders. This, arguably, is the Holy Grail of modern trading. Access to the live, pure data of other traders so that you can see whether they are in that ‘20% Club’ and if so the ability to then copy them until you feel that they may have run their course.

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Is Copy Trading Safe?

Copy Trading, as with all financial services, is not without its pitfalls. It is offered by a range of brokers and each broker is delivering a slightly different product and service and it is understanding all of this that is crucial to settling on a broker that is capable of delivering what you need. Some services require you to execute each trade, others allow full automation. Some allow historic trade data that is not real but theoretical, while others only ever allow real past trades to be published. Some offer an online only experience, others full telephone support. Some will hide running losses from graphical representations of performance or set no risk criteria by which a trader must be governed for the safety of others.

The key metrics you probably want to include when searching are:
  • Is my broker regulated by the FCA in the UK?
  • Is my money held in the UK?
  • Can I contact the dealing desk easily by telephone?
  • Are there charges or restrictions for moving my own money?
  • Are my trades executed as Spread Bets so tax free under current UK law?
  • Is the historical trade data that is shown comprised of real trades?
  • Has the history been created with a demo account?
  • Do I have to pay a monthly fee to follow a strategy?

 

Copy Trading is not the “fire and forget”, “everyone’s a winner” service that some firms and services will promote. Just like any financial product you still have to keep an eye on matters and be able to step in quickly if you wish to make changes. Being able to reach your broker’s dealing desk quickly, by telephone is still an essential factor when selecting your broker. You should categorically test whether this is feasible before lodging any money with any trading house.

Our personal view is that firms that place any kind of restrictions whatsoever on the removal of your own money from your trading account categorically tells you everything that you need to know about that broker. Run a mile.

Having your trades booked as spread bets will save you an enormous amount of hassle as a UK trader. You are aiming to make profitable returns from your trading so plan in advance to remove not just any tax liability but any HMRC reporting liability.

Back testing is a huge issue. It is absolutely fine to use back testing when designing a trading system and checking how your system would have responded in previous market conditions but it is categorically wrong to ever use back tested data to promote a trading system to others. It is not real data. It is not real performance. The biggest danger of a broker allowing a trader to upload historical trade data is that not only can it obviously be faked to make a trader’s strategy look good but any system can be curve fitted to look good but will collapse the instant it operates in the real world.

It is the same with trade history built up on a demo account. You want to know that the trader understands how to handle money not just pick demo trades on a platform that is not guaranteed to even be using the same market data as the real platform. Demo accounts are a sales tool; they have no discernible merit in regards to real trading.

Paying a monthly fee to a trader is a personal choice; there are pros and cons either way. Arguably, a trader who earns his income from a monthly fee is less incentivised to trade for the sake of trading but when you look at a trader’s true history you can see if they are doing this anyway. In terms of the cons, if you are going to be paying upfront for a system then you would want to know the background and professional qualifications of the trader in advance as well as their true historic performance.

What’s important to recognise regarding Copy Trading is that it has a place for every type of trader at every stage of their trading journey.

The Novice:

When you are just starting out on your trading journey being able to watch how other’s trade in a live environment and review all their past trades along with seeing clear metrics such as their risk scores, historic draw-downs and which markets they’ve been trading can be incredibly beneficial. While you can usually use a demo account so as to test traders to copy without risking any money another significant benefit is that looking at these traders can be an excellent source of trade ideas for your own account, or help you in confirming a view on where the market might be headed. Being able to look at the live trades of others has big benefits.

The Time Poor:

Most traders have other life commitments, whether that’s a job during the day, family responsibilities or leisure pursuits. This can make sitting in front of screens all day and analysing endless charts, technical indicators and fundamental data a possibility for only the most dedicated or deranged! End of Day trading systems have often been promoted as the solution but in addition the concept of Copy Trading means that another trader is doing all the time consuming analysis and all you are having to do is to make an initial decision as to whether to copy their trades, with how much of your portfolio and then monitor their performance just enough to know when it might be best to stop following them, increase exposure to them or decrease it.

The Normal Trader:

The normal trader is often ‘time poor’ as trading is not their full time occupation so the benefits above hold true here, as does the idea of using Copy Trading as a source for individual trade ideas. But in addition there are other benefits. Any trader knows that there are times when the markets are moving in a manner that simply don’t suit our trading style. We have all been there where we’ve had a nice long run of making good profits but we notice the market evolves its way of moving and while we have recognised this we just cannot get our style of thinking and trading to stay working during this period. Well, luckily we aren’t all the same and while we may be having it tough in the markets there will be other traders for whom this is the time they make their big returns and it is those traders which we can allocate some of our funds to following at times when our trading style doesn’t fit. We might also be a long only trader or only like to trade a particular market but recognise that another market looks very interesting, others are profiting but it isn’t our thing. In this type of situation you can seek out a trader who prefers short trading and add them to your portfolio so as to act as a hedge to your own trading style or add a trader in the market that you’d like exposure to but know that you don’t want to trade it directly.

The Experienced:

The absolute key to being an experienced trader is to know your weaknesses. Understand yourself well enough to know not just how you trade but understand how others trade. Having the ability to understand fellow traders opens huge opportunity in the world of Copy Trading. So long as your broker platform is sufficiently flexible to permit experienced traders to operate there are some tremendous advantages from adjusting the criteria under which you follow another trader.

In short, you apply your better experience to another trader’s activity, almost as if a mentor but purely for your personal gain. You might look at a trader and note that they trade one market better than you but another market not so, with a good system you can deselect specific markets from a trader that you are following so that those trades are ignored and not copied onto your account. Simultaneously, you might apply your expertise to note that he trades too large in a particular market due to over confidence and so you redefine the trade sizes for each market to dial out or even dial in risk.

All traders have draw-downs but being able to see each of a trader’s draw-down events and tie them in with the market conditions at the time you can see which market conditions don’t favour a trader and disconnect from following them when you notice those conditions returning to the market.

With a good system you can also add your own trades as well as close copied trades ahead of the trader or amend their stops and limits to better levels that you have spotted. Quite a few serious traders don’t like running overnight risk so being able to close out a trader’s positions on your own account booking any profits or losses ahead of the weekend or overnight can be very advantageous.

An experienced trader can usually take an average copy trader’s account and extract far better returns using these facilities.

Seeking Additional Income:

This is the bit that we have not touched on previously. You can obviously be one of the traders that others seek to copy and be paid by the platform for publishing your trades. For example if you trade using a third party trading system to generate your trade signals you can execute these onto your copy account and publish them for others to follow thus creating an additional income stream alongside your own trading.

Or, as we discussed for experienced traders, you could see a trader that you believe you could enhance their trades for better returns and publish those as a strategy to be copied. The scope is pretty limitless and studying the popular traders on a copy network will give a good insight in how to set yourself up to participate.

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