Copy trading – what is it and should you try it or is it a high-risk gamble?

by Jonathan Adams
Copy trading

JFK’s father Joe Kennedy legendarily made his money as a stock market investor during the raging bull market of the 1920s before making the astute and perfectly timed decision to sell his whole portfolio just days before the great 1929 crash. The story is that he sold up in the nick of time after a shoeshine boy started giving him stock market tips. That convinced him the market was in a bubble and he got out.

Days later, on Black Tuesday, billions were wiped off the value of the companies listed on the New York Stock Exchange. In the days, weeks and months after the Great Crash, America, followed by the rest of the world, spiralled into ten-year Great Depression that would last until 1939.

Joe Kennedy, however, was sitting pretty. He’d made a fortune thanks to his instinct that a shoe shine boy giving stock tips meant the market had become dangerously popular and was being fuelled by speculators.

In today’s world, stock and other financial markets trading tips are found more online than from the mouths of shoe shine boys. And there’s a huge amount of them out there. Investors and traders can either put their faith in the calls of particular tipsters. Or, like Joe Kennedy, take a contrarian approach and consider some tips as a warning sign to get out before a speculative bubble pops.

The rise of copy trading – what exactly is it?

As is the way of the digital world, entrepreneurs started to build online platforms that would make a product out of the every-man-woman-and-their-dog tipsters proliferating online. Called copy trading or social trading platforms, they went a step further than earlier stock tip message boards. They let short and longer-term traders and investors publish their actual positions in different financial instruments.

Not only do copy trading platforms see traders make their open positions publicly available, but they record the history of their overall success, or failure. And other traders can choose to copy all or some of the trades opened by those who make their record and positions public.

Copy traders can even choose to automate the replication of positions opened and closed by the public traders they have trust in. So even if they’re not online their trading account will mirror those trades. Possibly with values adjusted up or down to fit their own account size.

But what’s in it for the traders that allow others on the platform to copy their positions, other than the glory or the sating of a utilitarian spirit? That might motivate the occasional financial markets trader. But presumably not enough of them to drive the business of copy trading platforms.

But they also have a financial incentive. Copy trading platforms profit from trader transactions, because a margin is charged on positions opened. So the higher the volume of trades being made over the platform, the more money they make. The more traders with a successful track record that make their trading history public, and positions available to copy, the larger the numbers of inexperienced traders attracted to copy trading.

That drives up trading volumes and the copy trading platform makes money. A percentage of that money is shared with traders who have attracted copy traders. They get a cut of any revenue generated for the platform as a result of other traders copying them.

Sounds like a win-win. And it can be. There are certainly many positive arguments in favour of social trading. But there are also drawbacks. It’s perfectly possible, and not uncommon, for inexperienced investors to lose money copy trading. Traders with a seemingly strong track record can be copied and then their winning streak suddenly turns, to the detriment of anyone faithfully replicating their trades.

Let’s take a look at the arguments in favour of copy trading. And highlight the risks of how it can go wrong!

In favour of copy trading – the benefits

For most of us, learning from others who are more experienced and skilled than we are in a particular area accelerates our development. And even if we are experienced and skilled in something, we can always learn new things from others and continue to improve. In theory, that’s exactly what copy trading offers – a platform to learn from others.

Until relatively recently, inexperienced retail investors who wished to invest in financial markets had little choice other than buying into an investment fund run by a professionally trained, experienced fund manager supported by a team of professional researchers and analysts. The team would put in the hard yards analysing hundreds and thousands of investment opportunities, presenting those they considered to have most potential to the fund manager to take the final decision.

Retail investment funds essentially provide crowd-funded access to expensive, experienced expertise whose job is to grow the fund.

Copy trading is an evolution of that with the difference it is the platform that financially incentivises the investors who choose to make their investment decisions and historical performance public and transparent. Copy traders with less knowledge can then take their own decision on who to put their trust in.

Transparency is put forward as the key benefit of copy trading. Everyone’s actions and outcomes are visible to everyone else, with users of a copy trading platform learning from each other’s ideas, successes and failures.

Traditional investing via a fund is, by contrast, a one-way channel of communication. The investment manager shares regular updates on performance and decisions (though often there is a value threshold below which details of actions don’t have to be given) in the form of a factsheet.

For experienced traders and investors, copy trading platforms can also offer valuable insight into the investment herd’s mentality. They can then choose to follow that mentality or take a contrarian direction. As copy trading increases in popularity, the volume of data and opinions being shared on the biggest platforms can only offer improved insight into how the market is thinking at any particular moment in time.

Against copy trading – the risks

But there are two sides to every coin. If only it were as easy as finding an investor or trader with a strong track record of consistently generating positive returns and copying exactly what they are doing. Essentially for free.

The reality is the traders inexperienced copy traders are mimicking are usually themselves amateurs and most of them usually have a public track record that is no longer than a year or two at most. They haven’t had to pass any professional exams or be subject to checks by the Financial Conduct Authority, like traditional fund managers have, as much as they are often derided.

And the seemingly successful traders being copied by tens, hundreds and sometimes even thousands of trusting admirers also usually haven’t gone through the harsh, but wisdom-gaining lesson of a bear market. Fund managers usually have at least a decade, usually significantly more, of experience. They’ve seen the good times and bad and its tempered their decision making.

Even the worst performing fund managers got their jobs as a result of earlier periods of success. Usually over a far longer period of time than the traders being copied on copy trading platforms.

None of this is to cast doubt on the intentions of traders who allow followers to copy their strategies and positions. Many offer useful advice. But there are concerns about the market itself. In The Times newspaper, columnist Patrick Hosking warns of the copy trading phenomenon, while recognising it pluses, with:

“It seems to be based on multiple illusions about the share market, while exploiting human weakness — including the seductive reassurance that comes from doing what other people are doing”.

“The biggest illusion is that the past performance of a stockpicker over a short period of time says very much about their likely future performance. Another is that there are huge numbers of traders making fabulous returns. Prospective followers see only the tip of the iceberg. Etoro boasts how its top 50 PIs made returns last year averaging 29 per cent. It is harder to find out how the submerged other nine tenths did.”

Mr Hoskings further warns about the illusion many copy traders seem to be under that it is realistic to make returns of 30% while interest rates are at zero, without taking on a high level of risk. The kind of level that is not suitable for small, retail investors. He makes his point by comparing Warren Buffet’s average nominal investment returns over a 54-year period.

Mr Buffet is regularly referred to as “the most successful investor in the world”. His average nominal annual returns over more than half a decade are 20.3%.

There is also the valid point lead traders and copiers have different interests. Traders that allow others to copy them are incentivised to maximise past performance to attract more copiers, to earn more commission from their trades. The interest of the copiers, however, is their lead trader’s future, not past, performance. This disbalance incentivises lead traders to take on more risk, boosting their short term returns in a way that exposes them to a high level of risk that could well come back to bite their future performance.

In conclusion, copy trading has its pluses. It can be a useful, interactive, social way for beginners to gain a grasp of how financial markets and financial markets trading works. They can learn from others with more experience.

But the danger comes if beginners are sucked into the belief that annual returns of 30% or more are a consistently realistic prospect. And put money on the line they can’t afford to lose chasing that prospect.

If you are interested in copy trading, treat it as a learning experience. But be very aware of what is and isn’t realistic and limit your financial exposure accordingly.

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