COPY TRADING—DOES IT WORK?
There’s no doubt about it—there are professional traders out there who make money…lots of money. And one of the most interesting developments of late is a trend to enable wannabee traders to follow the trading behavior of those professionals in an effort to emulate their knowledge, their style, and hopefully, one day, their profits. However, as the saying goes, “there’s no such thing as a free lunch”, these copy trader websites should not be treated as a fast track to easy profits.
In the past few years, sites such as eToro, Naga Trader, and Tradeo have been set up to enable members of the general public to emulate the trading patterns of professional traders. The professional traders themselves earn commission from the number of followers they accumulate, and the website takes profits from the commissions paid by the site users.
For lay traders who don’t have the luxury of working in a bank or investment company where they can learn the tricks of the trade, copy trading could be the ideal opportunity. Open an account, choose a trader based on a number of criteria, and copy their trades. Seems simple. Maybe too simple.
However, there are risks involved with the practice of copy trading, including significant loss of much, if not all of your trading account. Naturally, lay traders should know this as any professional company should be ringing the message about potential losses from the rooftops. Yes, there are profits to be made, but, without applying sound money management principles, those profits can all too often turn to losses.
Trading is not the same as long-term investment. Not every position that a new trader will put on will make money. In fact, on average, something like seven trades out of ten will be closed out for a (hopefully minimal) loss. The idea is to run those other three trades for a significant profit that outstrips any losses that have been taken.
One of the major shortfalls of shadowing a professional trader is that the pros have “deep pockets”. They don’t set up their accounts with loose pocket change. They’re either trading their own accounts (if they are wildly successful, independent traders), or those of companies for whom they work. Either way, they can absorb losses that might wipe out a small trader. If those seven losing trades will delete the bulk of a lay trader’s account, then it won’t be long before that account is closed.
Another issue is finding the correct pro to follow. Some “professional” traders have 100%-win ratios as they never cut a losing position, hoping that the market will come back their way and they can turn a profit. At other times, when the market has turned against them, the pro can simply “average” a position by reducing its average cost in the hope that the market will turn in his favor. Again, this is a strategy that a lay trader cannot afford to copy.
Another pitfall of copy trading is not following the proportionality of a professional trader’s position. For example, if you are following a professional trader, but can only put up 10% of their position, then you must abide by that proportion come what may. Independently adding to winning positions (or averaging losing positions), without following the pro’s lead, can be fatal for an inexperienced trader.
All in all, copy trading platforms are a fantastic way for inexperienced traders to learn from the pros. But treat these copy trading platforms as an educational opportunity and not a guaranteed path to that free lunch.