Copy-trading can generate significant profits as well as substantial losses. Therefore, for this system to be effective, several considerations must be taken into account.
First of all, we have to know that we can trust the page where we will go to copy trade from, as well as the trader that we want to follow. The latter is the most complicated, since searching for a reliable platform might not be so problematic (although still essential).
The greatest difficulty arises when defining which trader to allocate resources to since this will be the one that manages the portfolio through its own operations.
Now that we have a broad idea of the potential profitability and the substantial risks of copy-trading, we are going to evaluate in more detail how a copy-trading system works and what features we have to take into account.
What is copy-trading and how does it work?
Copy trading is the practice of copying the operations of another trader, generally (and hopefully) a more experienced one and with a deeper knowledge of financial markets overall.
Copy-trading can be both automatic, in which case the trader issues a signal and the platform itself creates the relevant orders, as well as manual. In manual copy trading, the user receives a signal and can decide whether to follow it or ignore it.
“BUY AAPL PRICE: U$S 13.20 TP: U$S 16.50 SL: U$S 12.00”
In this example, we could receive that message via email, a WhatsApp group, a Telegram or Discord channel, or through a proprietary app, where we will have all the information to open a trade.
First, we can see that the signal they give us is “BUY”, then we can see the “AAPL” ticker, and then we have first the purchase price. Finally, the message includes two additional prices, which are not mandatory or necessary, but very important for risk management in general. As a general rule of thumb, it is recommended that you only follow traders who use at least the Stop Loss.
The Stop Loss (“SL”) protects us from having losses below the established threshold value since if the market price exceeds this limit, a sell order is automatically created to limit said loss. On the other hand, the Take profit (“TP”)is l responsible for issuing a sell order if the price exceeds the established limit, ensuring automatic profit-taking.
In the event that the operation is a short sale, the exact opposite occurs: The Stop Loss will be triggered when the price is above the limit value and the Take Profit when it is below.
As previously mentioned, another form of copy trading is automated copy trading, which works by first funding an account on a given platform. In this case, and unlike the previous one, (where one receives the signals but does not delegate the responsibility of creating the operations), these will be executed automatically on the platform when the followed trader does so.
In a nutshell, automated copy trading works as follows:
- First of all, the account from which the platform will take the funds to create the operations must be funded.
- The trader or traders you want to copy have to be carefully selected. This is by far the most important step.
- Every time the trader makes a trade, be it opening a position or closing an existing one, our account is going to replicate it.
Of course, regardless of being manual or automated, there are advantages and disadvantages that we will have to take into account before proceeding with this practice.
Advantages and Disadvantages of Copy-trading
- Ideal for those who are just entering the world of trading, since they do not need to have knowledge on the subject. They simply delegate the task to the person who is really trained, in this case, the trader. This does not imply that the investor can blindly trust traders.
- Suitable option for those who do not have enough time to do an analysis or execute their own trades, and want to leave this in the hands of other traders.
- In general, automatic operations are carried out by software, which executes really fast operations that a person would not be able not manually replicate. This is a really big advantage when it comes to very short-term operations, and is one of the reasons behind the increasing popularity of algorithmic trading in general.
- One can choose which trader to copy or simply diversify the portfolio amongst different traders.
- By choosing several traders simultaneously with different trading modalities, we will be able to diversify our exposure to specific risks. It is important for these traders to be as uncorrelated from each other as possible.
- There is an adverse selection filter, where the traders that recently performed the best are selected. This is often due to high leverage, poor risk management, and luck.
- Market risk is always present, even if a trader has excellent past results. A regime change in the market can eliminate the source of profitability of a strategy.
- Past results are not indicative of future results. Having said this, those traders with a long and stable track record (and a max. drawdown that is tolerable) should be prioritized.
- In manual copy-trading, one must be present 24/7 in order to trigger the signals received at that moment. Otherwise, a delay in execution could cause the results to differ between the trader and the person who is copying them. In fact, it could even result in losses if trades are opened too late, even when the copied trader has made a profit.
- All operations are subject to commissions, which can be from the trader that is being copied, as well as from the platform itself. As a consequence, the profitability obtained is less than that of the trader (even when successful).
- Many platforms recommend the traders who had the most profits in the most recent period (a couple of months), which does not allow to correctly assess the track record and the replicability of a trader’s strategy.
- We must bear in mind that the operations that are made, whether manual or automatic, come from humans and are therefore prone to errors, in which case they could end up in losses if they are not rectified accordingly.
How to choose a trader to copy
The choice of traders is really the biggest challenge that we must take into account. There are countless traders offering themselves in the market, which makes it difficult to filter them properly.
By assigning funds to a trader, we are logically exposing our investment to several risks, so it is reasonable to look for a responsible professional with extensive knowledge. It is important not to choose solely based on the trader’s most recent returns, but also to quantify the risks incurred to obtain them.
Therefore, there are several metrics to take into account when analyzing the statistics of a trader.
Leverage is a way to get much larger returns but at the cost of increased risk. For example: Let’s consider a hypothetical case in which you open a trade with $100, and the price increases by 10%.
If we close the trade we would get $110 (without taking commissions into account). Now, let’s assume that said trader made the same operation but leveraged in a 100:1 ratio. This is indicating to us that the capital with which the operation is opened is no longer US$100 but 100 times larger. That is, US$10,000. As a consequence, as capital increases, so does risk.
In the example above, without leverage, a 1% movement in price is equivalent to a $1 change in our account. Likewise, with 100:1 leverage, a 1% movement in price equals a $100 change. For this reason, if the price moves in the opposite direction by 1% with leverage, we will have lost $100. Considering that our initial capital was $100, our entire account would be wiped out with only a 1% change in price.
As can be seen from the example above, leverage is a double-edged sword, more so if it is not used properly and coupled with good risk management.
Although risk management is a topic that deserves more than a paragraph (there are entire books on the topic), we can analyze the following metrics and evaluate if they align with our risk tolerance:
- Leverage: an increase in leverage results in a proportional increase in the returns and losses of a strategy and, as a consequence, in its total risk.
- Profit/Loss Ratio (Profit/Loss): there are strategies with a strongly asymmetrical P/L profile, in which the vast majority of trades end in small profits. In contrast, losing trades, although few in number, are strong in percentage terms (see example related to leverage).
- Max Drawdown (MD): this indicator allows us to determine the maximum loss that a strategy suffered during the historical period considered. A MD of 50% may be intolerable for an investor in a real-life scenario, so he must previously determine the maximum Maximum Drawdown that does not lead him to withdraw his funds.
As we can see, high profitability generally comes with high risk, which is why it is essential and very important to analyze all these concepts before rushing into simply choosing the most profitable trader.
How to choose a copy-trading platform
There are many platforms that offer copy-trading services. While some are dedicated exclusively to this practice, other platforms are mainly brokers that also offer a copy trading service. This is beneficial if, in addition to copy trading, you want to create operations on your own.
There are platforms that require us to open an account with a broker of choice, and others specifically ask us to open an account with a particular broker and link it to a social trading account to copy trades.
It is important to evaluate to platform’s regulations in detail before opening an account and funding it. In addition, fees and commissions have to be taken into consideration. A strategy that is profitable for the trader could lead to consistent losses for the investor if they do not properly account for these additional costs.
Popular Copy-Trading Platforms
|AVA Trade||Forex, Crypto, Stocks||400:1||0.9 Pips||FCA, ASIC, FSA, MiFID, CBI, FRSA|
|IC Markets||Forex, CFDs, Commodities, indices, Stocks||500:1||0.1 Pips||ASIC|
|FXTM||Forex, CFDs, Stocks||2000:1||Up to 0 pips||CySEC, FCA, FSCA, FSC|
|AXI Trader||Forex, CFDs, Commodities||500:1||0.1 Pips||FCA, ASIC, FSA, DFSA|
|Etoro||Forex, Stocks, Crypto, Commodities||30:1||0 Pips||CySEC, FCA, MiFID, ASIC, AFSL|
|Admiral Markets||Forex, CFDs,||500:1||0.5 Pips||CNMV, FCA, CySEC, FSA, JSC|
How do traders in copy-trading platforms earn money?
A question that often arises is, what do traders earn from being copied?
The answer is that, in addition to generating profits from their own trades, traders also earn profits via follower commissions. Additionally, on some platforms, they receive bonuses for maintaining certain requirements, which can be a regular presence on the platform, passing certain risk management metrics, and even maintaining a stable flow of publications in order to engage with their followers.
Therefore, it is an incentive for them to have good returns with good risk management, in addition to increasing the number of followers.
Having said that, although the incentives via returns are aligned between the trader and the investor, there are other incentives that antagonize them.
It is common practice for platforms to offer benefits for the volume traded. As a consequence, all things being equal, traders favor those strategies that require a larger number of trades. Taking into account that the commissions paid by traders are lower than those paid by investors, a greater number of operations hurts investors disproportionately more.
As can be seen, copy trading is by no means a magical source of profitability and investors should thoroughly evaluate the profitability of the traders that they want to follow. It is somewhat misleading to sell these types of services as solutions for inexperienced investors since they should know how to properly evaluate the performance of traders.