What is copy trading?

Copy trading allows traders to copy trades executed by other investors in the financial markets. There are several ways to copy trade another investor. For example, a trader could copy all the transactions, including trade-entry, take-profit and stop-loss orders. Alternatively, they could receive notifications of trades and manually copy these transactions.

The goal of copy trading is for the trader to have the same positions as the investor they are copying. When copying another trader, one doesn’t receive the layout of the trader’s strategy, but simply follows their trades blindly. This compares with mirror trading, which allows one to copy a trader’s actual strategies.

Copy trading was born out of mirror trading in 2005. Initially, traders copied specific algorithms that were developed through automated trading. Developers shared their trading history, allowing others to copy their strategies. This scenario formed a social trading network. Eventually traders began to copy trades in their personal trading accounts, copying another trader rather than a strategy.

What are the benefits of copy trading?

Copy trading is a form of portfolio management. The goal is to find other investors that have a track record you would like to emulate. The process of copy trading allows traders to monitor strategies of other successful traders. Like any trading system a trader decides to employ, traders are best served by following the investor before they decide to risk real capital.

Copy trading can be useful for traders who don’t have the time to follow the markets themselves. Generally, copy trading is focused on short-term trading, but there are several different strategies that are used to generate revenue. The assets that are used focus on the foreign exchange market and contracts for difference. While copy trading can be lucrative, there are also risks involved, and traders should remember that past results are not a guarantee of future returns.

DIVERSIFYING YOUR PORTFOLIO

Copy trading allows traders to diversify their portfolio. This means that a trader is using multiple ways to make money in the markets. Instead of putting all their eggs in one basket, traders can use multiple strategies. When copy trading, you should consider using a few different traders to copy.

One way to diversify is to find copy traders that trade on different financial instruments. For example, one could copy a forex trader as well as a commodity trader. They could also consider copying traders that use different time frames. One might be an intraday trader and another could be a longer-term trader. Traders that experience high volatility on their returns compared to those that have low volatility on their returns could also be considered. Lastly, one may consider very active traders compared to less active traders. Remember, however, that if something appears too good to be true, it probably is.

The business model used in copy trading can be lucrative. Most copy trading businesses are subscription models, where an individual pays a fee to copy traders every month. An alternative model that can be used is revenue sharing. Here one receives a certain percentage of winning trades.

What are the risks of copy trading?

The greatest risk a trader will face when copy trading is market risk. If the strategy a trader is copying is unsuccessful, they can lose money. Traders also face liquidity risk if the instruments they are trading experience illiquid conditions when markets are volatile. Lastly, traders can face systematic risks if the product they are trading experiences sharp declines or rallies.

Market risk

Market risk describes the risk of loss due to changes in the price of a security. The goal is to generate gains from an increase in the value of the asset being traded. Obviously, there is a risk that the asset will lose value.

Traders can protect themselves from market risk beyond what they expect to lose by using an asset allocation strategy. This means that only a certain amount of funds are allocated to a certain strategy. By allocating all their assets to a single trade strategy, a trader could face large losses if an unexpected event occurs, and this could wipe out your entire capital.

Traders can diversify their portfolio by allocating their capital to multiple strategies. A diversification strategy can help traders make money in several types of market environments. Many strategies rely on trending markets. If an individual chooses only traders that perform well during these periods, they could end up losing money in sideways trading market conditions.

Liquidity risk

Liquidity risk means that one may not be able to exit positions at expected levels. A strategy’s risk management method should have a historical precedence so the trader can see the copy trader’s maximum historical drawdown. The maximum drawdown shows the peak-to-trough decline during the life of the strategy. This is a very important figure as it lets traders see historically the maximum amount they may be comfortable losing at any given time if they choose to enter the strategy. For example, a copy trader may have a maximum drawdown of 20%. This means that one can expect to lose at least 20% at any point once they start copying the trader.

It is also useful for traders to gather information about the products and asset classes they are trading. This is because each instrument has a different liquidity level. For instance, it will be much easier for a trader to exit positions in EUR/USD, as compared to liquidating emerging currencies. When copying traders focusing on emerging market currencies, one should examine the slippage incorporated into their returns. Slippage can be significant during periods of heightened volatility.

Systematic risk

Emerging market currencies are more exposed to systematic risks. This means that one’s money could get locked up and the trader may not be able to exit their positions. This has happened in the past when countries are overthrown and capital is locked up and forbidden to leave. While this scenario is very rare, it needs to be included in a strategy where this situation could happen, especially in the foreign exchange market.

Copy trading versus mirror trading

There are slight differences between copy trading and mirror trading. The definition of mirror trading is mirroring a trading strategy. Traders mimic the trading style or trading strategies of other traders. Initially traders were interested in specific algorithms that were developed and developers shared their trading history. Traders would find algorithms with strong returns and then copy their results, asking the developers if they could follow their strategies. Copy trading was born out of mirror trading.

With copy trading, one doesn’t receive the layout of the copy trader’s strategy. Instead, they follow the trader’s trades blindly.

Summary

Copy trading is a portfolio management strategy where one copies the trades of another trader, tracking the performance of that investor. There is also an automated version of copy trading where one’s trades are automatically transacted. A manual version will allow a trader to execute their own trades. The manual version offers discretion, and if one employs their own discretion, they should expect the returns to be different relative to the historical returns of the copy trader.

One should only allocate a certain portion of their capital to an individual copy trader. If a trader has a specific capital pool allocated to copy traders, they should diversify to make sure they do not risk all their capital with a single trader.

There are several risks that traders can face when copy trading. Market risk is the most prevalent. Before risking capital, you should make sure you are comfortable with the copy trader’s maximum drawdown. This is the peak-to-trough drop in capital which can happen at any time. This means that while a copy trader’s historical returns might be large, if an individual begins to copy the trader when he is at his peak, they could experience a bad patch.

If you hold your position past 5pm New York time (10pm UK time), your account will be debited or credited at the prevailing holding rate. If you have bought a higher yielding currency you may receive interest; if you have bought a lower yielding currency you may be charged interest.

Traders also need to be wary of systematic risk. This is where you copy traders who speculate on emerging market currencies, as they could run the risk of their capital becoming locked up.

Before starting copy trading, a trader could consider opening a demo account and manually copy the trades to see if the returns are as profitable as had been expected.

Source: CMC Markets UK