A group of researchers did a study on Brazillian day traders between 2013 and 2015.
They wanted to find out how many % of traders made money consistently.
And do you know what they found?
- 97% of them lost money
- 0.4% earned more than a bank teller (about $54 per day)
- The top trader earned $310 per day
Clearly, the odds are against you.
So what now?
Well, that’s why many traders hop onto the copy trading bandwagon.
After all, you’re thinking:
“Since trading is so difficult, then why don’t I follow the trades of a pro trader—without having to figure things out on my own?”
From the look of things, it makes sense, but there are a few “hidden” pitfalls that nobody tells you (and I’ll cover more later).
But first…
What is copy trading and how does it work?
Copy trading is when you follow the trades of another trader.
So when the trader buys, you buy. When the trader sells, you sell. When the trader adjusts his stop loss, you’ll adjust it as well.
Here’s how it works…
There are 2 types of account in copy trading:
- The master: This is the person who makes the trading decisions
- The follower: This is the person who copies the trades of the master
Also, the masters and followers are on a platform (like Etoro and Darwinex) which facilitates copy trading—and it’s how they connect.
Now:
I know you’re excited to fund your copy trading account and copy the trades of other professional traders.
But before you do so, here are some things about copy trading you must be aware of.
Read on…
Copy trading: Why you won’t have the conviction to copy for long
Here’s the deal:
You’ll never know who is the person that you’re copying your trades from.
Sure, they can give some short biography about themselves, how they trade, etc.
But how do you trust their trading strategy if you have not validated it yourself?
Because when the drawdown comes (and it definitely will), you’ll start having thoughts like…
“What’s going on?”
“Did the trading strategy stop working?”
“Should I still copy the trades after 5 losers in a row?”
Now, these questions are impossible to answer because you didn’t develop the trading strategy. Instead, it’s copied from another trader and that puts you in the back seat.
Do you agree?
Beware of transaction costs and fees
Copy trading is a business.
So, if you’re not being charged any upfront fee, then you’re paying more for the spread and overnight fees.
I’ll explain…
The spread
For most Forex brokers, the spread on EUR/USD is 1 pip. But on a copy trading platform, you might pay 2 to 3 pips more.
But don’t take my words for it because you can compare the spreads of a normal Forex broker with a copy trading platform and you’ll see the difference.
So, what’s the implication?
Two things.
#1: If you’re a trader being copied, then bear in mind your trading strategy won’t work as well because you’re paying more in spread (compared to a typical Forex broker).
#2: If you’re copying another trader, then it’s best to follow traders who trade infrequently so the spread doesn’t eat up a huge chunk of your profits.
Overnight fees
Now, the spread isn’t your only cost because you still have to consider overnight fees (if you’re holding positions for longer than a day).
This fee is calculated by taking Libor + X%.
(Libor stands for inter-bank offered rate. It’s an interest rate that banks charge to other banks for borrowing the money.)
So, what is X?
Well, this is the mark up that’s determined by the copy trading platform and you’ll need to check with them for the exact amount.
The good news is, you don’t have to worry about calculating all these because the platform will likely do it for you—so do check it out before placing a trade.
Now, there are probably other fees to consider but the spread and overnight fees make up the chunk of it.
Moving on…
Beware of a possible conflict of interest
As a master trader, you get paid more as your number of followers increase (that’s because you have a larger amount of assets under management).
So the golden question is…
How do you increase your number of followers?
One technique is to adopt a high winning rate trading system (like having 500 pips stop loss and 5 pips profit target).
Clearly, with such a trading methodology, your equity curve will be sloping higher for a long time— which will entice new traders to follow the master.
But there’s a problem with this.
It’s only a matter of time before the trading system encounters a loss and wipes out all the earlier gains (or more).
And by the time it happens, the master trader would have already profited from his “fees” and the ones left suffering are the followers.
Now, I’m not saying all masters are bad, but you must be aware of this possible conflict of interest.
And if you see an equity curve sloping “too nicely”, that’s usually a cause for concern.
How to find copy trading success?
At this point, it seems that I’m against copy trading—and you’re right.
Still, if you want to go down this route, then here are some tips to help you…
#1: Understand the concept behind the trading strategy
When you understand the concept behind a strategy, you’ll know why it makes money which helps you stick to it.
For example:
Trend following works when markets are trending. But statistically speaking, most markets trend less than 50% of the time.
This means you’ll lose often, but when you catch a trend, your profit will more than compensate for the little losses you incurred along the way—and that’s how a trend follower makes money.
Now if you don’t understand the logic behind trend following, then you’ll claim it doesn’t work after a few losing trades.
But if you do, then you know it’s simply the cost of doing business.
#2: Know the person you’re copying from
In the venture capital world, some firms get funded not because they have a good product or idea. Instead, they get funded because of who’s running the company.
And this concept can be applied to trading.
Let me explain…
I’ve got a friend who’s into Algorithmic FX trading. The way he trades is by having a wide stop loss and small target profit. If the market moves against him, he’ll average into his losses so he can quickly recover back when the market reverses back in his direction.
This works for him because he risks less than 0.5% on each trade and if he is wrong on a trade, he’ll average into his losers so he can quickly recover when the market reverses back in his direction.
To be honest, I’m not in favour of such a trading strategy.
But because I trust the integrity of my friend more than his strategy, I’m willing to invest with him.
#3: Diversify your masters
If anyone promises you that you can make money every single day, week, or month—run far away.
That’s because no trading strategy works all the time as market conditions are always changing.
Think about it:
The only way a trading strategy makes money all the time is IF market conditions don’t change—and that’s impossible.
So, what now?
Well, all hope is not lost because you can adopt multiple uncorrelated trading strategies and smooth out your returns over time.
For example:
Stock momentum trading works well in bull markets, but during a recession, it suffers a drawdown.
So what you can do is, adopt an uncorrelated trading strategy like futures trend following which usually does well in a crisis period.
This way, your losses from stock momentum trading gets “subsidized” from your futures trend following strategy.
So the takeaway is this…
You want to copy trades from different masters with uncorrelated trading strategies—so you can improve your returns relative to risk.
#4: Find masters who have a stake in it
I’ve got a question for you…
There are 2 identical business out there (A and B) which sells vacuum cleaners.
The owner of business A has 50% of his wealth invested in the business.
The owner of business B has 5% of his wealth invested in the business.
Now let me ask you:
If everything else is constant, which business do you want to invest in?
Business A, of course.
Why?
Because the owner has more at stake. In other words, he’ll likely do the right things as he doesn’t want to jeopardize his investment—which is aligned with the interests of the shareholders as well.
So, what has this got to do with copy trading?
Simple.
You want to identify masters who have a decent stake in their account because they will do what’s right—and this benefits you the follower (aka the shareholder).
Conclusion
Copy trading allows you to follow the trades of another trader.
You must be aware of things of like transaction costs & fees, a possible conflict of interest, and how you’ll have difficulty following the trades of another trader.
Still, if you want to go down the copy trading route, then here are a few tips to help you…
- You must understand the concept behind the strategy, so you don’t give up after a few losing trades
- You have confidence in the person you’re copying from
- You diversify between different trading strategies so you can improve your returns relative to risk
- You identify masters who have a stake in it so there’s no conflict of interest
Now here’s what I’d like to know…
What’s your take on copy trading?
Leave a comment below and share your thoughts with me.
