The Pros and Cons of Copy Trading

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The Pros and Cons of Copy Trading

Copy trading is an investment strategy where you copy someone else’s trades. It’s a simple concept and can remove a lot of the stress of making your own decisions. 

This trading strategy provides you with the opportunity to use more experienced traders’ transactions to generate returns for yourself in the future.

In our recent articles, we talked about the use of automated trading as a way to circumnavigate some of the issues caused by trading psychology for new traders. A natural alternative to auto trading is to look at copy trading.

When copy trading you will eliminate the need for your own market research and your own emotions that can affect your trading performance, especially as a beginner trader. 

Instead, your job will be to find the best traders to copy and to track how good of a job they are doing.

 

Source: digitcoinz.com

Please note: Copy trading is not a route to free money! It requires monitoring how long you want to stay exposed to a particular trader and emotions can still hinder good decision-making. Copy trading requires putting your faith in a stranger and because you don't know the trader you are copying, it is challenging to determine whether they have the same financial goals that you are attempting to achieve.

In this article, we will explore more of the pros and cons of copy trading and hopefully help you make a decision where it's right for you. 

What is Copy Trading?

The copy trading process is straightforward. You pick a trader, and for each trade that the trader transacts, you also transact. The transactions you place are identified by the trader you decide to copy. The track record of each trader that you can copy should be available with performance statistics for you to analyse and compare.  

 

Source: forexillustrated.com

Some copy trading platforms will allow you to trade automatically, while others will notify you of the trades you should copy. True copy trading is done automatically, whilst trade notifications are really more of a trade signal service.

Some of the advantages of copy trading include:

• Your ability to analyze the historical performance of traders you are copying


• Find traders that meet your return criteria


• Eliminates time that you might need to perform research


• Evaluate traders that have high and low turnover rates


• Collaborate with other traders who are in a copy-trading community


• You can create a diversified portfolio of traders

Some of the disadvantages of copy trading include:

• You give up some control, including risk management


• The psychological impact of giving up control of your trading


• You must trust that the trader you follow has their trading psychology under control


• You might not have the same long-term financial goals as the trader you follow

A more personal fund-of-funds

A copy trading strategy can be thought of as a retail trader version of what larger institutions do when they invest in a 'fund-of-funds'. A fund-of-funds is simply a fund that invests in other funds. This is done to gain exposure to the strategies of different fund managers all within one portfolio. As a retail trader, you can copy the trades of numerous professional traders, in effect having your own fund that employs a diverse range of trading strategies employed by different traders. 

A managed fund is a form of copy trading. There are managed fund operators who provide this service for accredited investors. They will provide access to some of the more reputable hedge funds they have screened and determined to meet a specific trading profile. 

Your job as a copy trader is to find one or more traders that you can copy that has a trading style you are looking to invoke but provide reliable returns more efficiently than you. 

How to Trust Bots with Your Capital

At this stage, we can bring today's subject matter in line with our series of articles on automated trading. One form of copy trading that eliminates any element of the human trader and the potential psychological issues they might face is copying a bot.  

A 'bot' is the short name given to an automated trading robot, a computer program that generates systematic trading returns. A trading bot will use different sources of information to create trading strategies. 

1. Make sure risk management is part of the bot

A good bot includes all of the risk management associated with the trading strategy to make it viable to copy with a hands-off approach.

1. Evaluate historical performance

The best way you can trust a bot to trade your capital is by evaluating the historical performance of the bot. With regard to historical performance, you want to make sure that there is a long data series. The more data available, the greater the chance that the historical performance can repeat into the future. 

1. People/forums you trust

Knowing somebody you trust or a group of people from a forum you trust using that bot can give you extra confidence and gives you one extra data point for trustworthiness to reply on above the historical performance.

1. Check for 'curve fitting' 

You want to be careful that a bot is not 'fitting the curve'. This is a technique where the trading strategy is 'optimised' by its creator so much that it will only work in the exact circumstance of the past price action. The problem here is that the future never perfectly repeats the past and the strategy will not be 'robust' enough to work when the price action changes.

The Psychological Impact of using Bots

Control: If you decide to trade using a bot, you need to believe in the system and not become overinvolved. If you are the kind of person that needs control, and will not feel comfortable taking drawdowns, then a bot is likely not for you. 

Patience: The bot will try your patience. There can be outsized gains, followed by drawdowns that you must be psychologically prepared to accept to achieve the advertised return potential of the bot.

Emotions: The benefit of using a bot is that you remove the emotion of trading. You don’t have to do any research, and you don’t experience the ups and downs of each trade. 

Expectations: The challenge is your ability to give the bot the time it needs to generate the expected returns. Set realistic goals and a plan of action for if the bot does not meet your expectations. If you expect 1% returns each week and are not achieving that goal, you should remove your capital and look for a new bot after a predetermined period.

How to choose the best Copy Traders (and errors to avoid)

When you use a copy trader, your job becomes risk management.  By reducing the amount of time you need to perform trading research, you will have more time to evaluate the returns from the trading strategies used by the traders you follow. 

The best result you can hope for from copy traders is that they match their historical performance. This gives you stability.  

Risk/Reward: Remember that the reward you receive is predicated on the risk you take. Traders with a track record of high returns generally have to accept higher levels of risk to achieve those returns. To give yourself the chance of high returns, you will need to accept larger drawdowns and a bigger chance of margin calls or an account blow-up.

Forward testing: If you want to start copy trading, you should risk small amounts of capital initially. Ensure that the returns that occur over a specific period match your expectations. The process is called forward testing, and it will help you gauge if the traders you are copying are right for you. 

Diversification: You also want to try to find multiple traders.  You might want to forward test using numerous traders before you increase the size of capital that you use for copy trading. This situation will allow you to experience diversified returns. If one trader underperforms, another might outperform and help you generate the overall returns you are looking to achieve. 

Good broker: Find a reputable broker that has a system in place to evaluate the performance of a copy trader specifically. This scenario provides you with another layer of trust. It would also help look for traders with a relatively lengthy track record. This type of trader probably has executed a strategy through multiple trading conditions. Some traders are only good when a market trends, which means you want to ensure that you have enough information to determine the strengths of the trader you decided to copy.

Track Record: You want to avoid copy-trading someone with only a few trades under their belt. It’s also essential to give the trader you decide to copy enough time to generate the returns you expect. For example, if a trader returns 50% annually and has at least one 20% drawdown per year, you need to be comfortable knowing that you could be exposed during the drawdown and will be willing to live through it. 

Copy trading summary

In summary, copy trading is a strategy for copying other traders and generating your returns using their trades. You can do this automatically. Your job is to find the traders that will provide you with the returns you are looking to achieve. 

Your long-term financial goals might not align with a trader you are following, and that is why it’s important to evaluate many traders to determine if they conform to your expectations. You should start with small capital and use several traders to generate a diversified portfolio. A pitfall is losing some of the trading control when you copy trade. You become more of a managed fund that uses several traders instead of trading individual assets. 

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