The year 2005 was significant for two reasons. For starters, the massively popular MT4 trading software was released by MetaQuotes. Secondly, in the same year, investors and brokers realized how the sharing of trades could become more seamless and cheaper.
Instead of expert traders broadcasting their positions in chat rooms for others to follow, they could host their strategy in an autonomous trading system for them. Tradency was one of the first to implement this concept successfully.
Since then, copy trading is now more straightforward and automated and is particularly popular with forex. This article will dive into more about this style of trading, how it works, the pros and cons, and tips for selecting the best platform offering this facility.
What is copy trading?
The terms ‘social trading’ and ‘copy trading’ tend to be used interchangeably. Social trading is merely an umbrella term referring to investors interacting with expert traders by copying their positions, watching them in real-time, and learning about their strategies.
Copy trading is a subset of social trading and is the main mechanism for trade execution. Investors can perform these actions on a specially designed platform hosted by a broker. The expert traders which investors copy from are selected by the broker and will build up a following by showing profitable results over time.
As the experts, investors can view their performance, behavior, outlook, and stability data and choose the person suiting their goals and risk appetite. Like any social network, social trading encourages engagement through likes, comments, and link sharing.
The appeal of such a service is one does not need to have specialized proficiency in the markets as they take advantage of the skills and positions of those more experienced. Unlike a PAMM account, which shares many similarities, there is little contractual commitment as investors are free and flexible to switch between or diversify across expert traders.
The minimum deposits with many established social trading networks have increasingly become more affordable, although this still varies across different managers. Furthermore, copy traders can add or remove their funds at will.
How are trades copied?
In a copy trade, we have a system involving the expert trader and investor. The platform automatically copies the positions from the former’s account in proportion to the allocated funds of the investor.
So, for instance, if the expert trader risks 1% of their equity, the same allocation also goes to the copier. When the expert trader’s account loses or gains this percentage, the exact allocation applies on the investor’s side.
The platform automatically assigns stop loss and take profit orders and will close the trades if the same action occurred with the expert trader. However, investors do have the liberty of exiting positions manually.
Regarding fees, most copy trading facilities allocate a small fee towards the strategy manager for any closed position, or the manager takes a specific commission percentage of the profits. The spreads from the broker remain the same for investors as they would normally.
Pros and cons of copy trading
Like any financial endeavor, while the potential upside is clear, there are unignorable downsides as well.
- Less knowledge required and free time: For the less knowledgeable investor, copy trading could be less intimidating and complex than committing several years learning the craft themselves.
As copy trading is autonomous, this allows copiers more time to dedicate to doing something else rather than analyzing the markets.
- Diversification: Traders who have some proficiency can also benefit from copy trading; it’s not limited to those with little or no knowledge. Both parties benefit from diversification as they can leverage from a myriad of different strategies aiming to exploit several trading environments.
It might be a viable option for anyone considering an alternative strategy to their traditional methods but might not have the time to develop it themselves.
- Knowledge upskill: As a social network, copy traders can learn new strategies and techniques from those they are copying. Strategy managers should explain how they trade and their thought process into some of their profitable positions.
- Financial risks: Even though investors do not actively make any positions, the risk of monetary loss isn’t necessarily reduced. Like any strategy, past performance is never any guarantee of future results; drawdowns are inevitable.
Also, investors are also exposed to general execution anomalies such as slippage and widening of spreads, both events that could lead to unfavorable order fills.
- Discretion is not possible: With discretionary trading, one has more control over whether to take a position or not through the immense knowledge they’ve acquired. In copy trading, the investor relies on another trader’s instincts, and it is not always possible to understand everything about their decision-making.
Tips on selecting the best copy trading platform
Names of the well-known copy trading services include the likes of eToro, ZuluTrade, Darwinex, Myfxbook, etc.
Regardless of the brand, any brilliant copy trading facility should be user-friendly, have reasonably quick depositing and withdrawal options, responsive customer support, provide a wide range of expert traders and show all the necessary performance metrics.
Arguably, the most crucial step for any potential copy trader is understanding how to best evaluate the consistency of anyone they consider copying. While a high return rate is attractive, it doesn’t paint the complete picture. Below are the crucial metrics to consider:
- Account age: This is a telling statistic showing the longevity of a trader’s system. Investors should stick with accounts at least a year old. While those with less history and impressive gains in the short-term seem attractive, they may not necessarily be genuinely risk-conscious and prioritize consistency.
- Drawdown: If talking purely of a trader’s ability to manage their money in a risk-conscious way, this statistic should be the first to consider. A drawdown refers to the percentage reduction of an account going through a losing period.
Analysts generally recommend a rate below 20% as acceptable, making it possible for a trader’s equity to recover. Anything above this figure should be a red flag and shows the strategy manager has a high risk of ruin.
As with any investment, investors should always carefully assess the risks, especially if their forex knowledge is limited. Potential users of any copy trading platform should spend sufficient time in picking the right manager aligning with their goals and risk tolerance.
Despite the clear advantages of this service, it’s not a suitable avenue for everyone. In some cases, it may be worthwhile in the long run for an investor to dedicate their time towards learning the craft of trading.