A group of researchers once conducted a study of Brazilian day traders between 2013 and 2015. They wanted to know what percentage of traders consistently make money. And do you know what they found? 97% of traders lose money. 0.4% earn about $1,500 per month. And only the very best earned about $10,000 a month.
Obviously, the odds in trading are working against us. This is why many traders prefer to copy trades of other traders. They think, "Because trading is hard to make money, why don't I follow the trades of a professional trader without having to figure everything out on my own?"
At first glance, this makes sense, but there are a few "hidden" pitfalls that no one will tell you about. In today's article, we will try to understand everything.
What is copy trading?
Copying trades is when you follow the trades of another trader and repeat them in your terminal. When a trader buys, you buy. When a trader sells, you sell. When a trader adjusts his stop loss , you also adjust it.
There are 2 types of traders in mirror trading :
- A master is a person who makes trading decisions.
- A follower is a person who copies the master's trades.
In addition, masters and followers use a special trading platform that facilitates copy trading.
As I wrote, this type of trading has its pitfalls. First, you never know who you are copying your trades from. Of course, you can find out a trader's brief biography, see how he trades, etc. But how can you trust someone else's trading strategy if you haven't tested it yourself?
Because when the drawdown comes (and it will definitely come), you will have thoughts like: “What is going on?” “Trading strategy stopped working?” “Should I still copy trades after 5 losses?”
These questions cannot be answered because you have not developed a trading strategy. Instead, you are copying trades from another trader, and this makes you dependent on other people's results.
Beware of transaction costs and commissions
Copying trades is a business. If you don't get charged up front, then you usually still pay for the spread and commission.
For most Forex brokers, the EUR/USD spread is 1 pip. But on a copy trading platform, you can pay 2-3 pips more. What do we end up with?
- If you are a copy trader, keep in mind that your trading strategy will not work because you are paying much more for the spread.
- If you are copying another trader, then it is best to keep an eye on traders who trade infrequently so that the spread does not eat up a huge portion of your profits.
The spread isn't your only cost, because you still need to account for the nightly rollover fee (if you hold positions longer than a day). This fee is calculated based on the Libor + X% rate. Libor stands for Interbank Offered Rate. This is the interest rate that banks charge other banks for borrowing money.
What is X? This is a markup that is determined by the copy copy platform and you will need to check with them for the exact amount. The good news is that you don't have to worry about the calculations, simply because the trading platform will do it for you.
Beware of conflicts of interest
As an experienced trader, you get paid more as your following grows (simply because you have more assets under management). How to increase the number of subscribers?
One way is to use a high profit trading system (for example, have a 500 pip stop loss and a 5 pip profit target). It is clear that with such a trading strategy, your capital curve will rise, which will encourage new traders to follow you.
But there is a problem here. It is only a matter of time before it enters a drawdown and nullifies all its previous achievements. By the time this happens, the master trader will have already profited from his “fees”, and those who will receive a loss are his followers.
I'm not saying all traders are bad, but you should be aware of this potential conflict of interest. And if you see that the capital curve is too beautiful, you should be worried.
How to succeed in copying trades?
By now, you probably understood that I am against copying trades. However, if you want to go down this path, here are some tips to help you.
Understand the concept of a trading strategy
When you learn the concept of a trading strategy, you will understand why it makes money, which will help you stick to it.
For example, a trend trading strategy works when the markets are trending. But statistically speaking, most markets trend less than 50% of the time. This means that you will often lose, but when you catch a trend, your profit more than compensates for the small losses that you have been taking all this time. This is how a trend follower makes money.
If you don't understand the logic of trend following, you will tend to argue that a trading strategy doesn't work after a few losing trades. But if you understand everything correctly, then you know that these are just inevitable costs in trading.
Know the person whose trades you are copying
In the world of venture capital, some firms don't get funded because they have a good product or idea. Instead, they get funding because of who runs the company. And this concept can be applied to trading.
I have a friend who is engaged in algorithmic trading in the foreign exchange market. He trades with a wide stop loss and a small profit target. If the market moves against him, he will average out his losses so he can recover quickly when the market turns in his direction.
This works for him because he risks less than 0.5% on every trade. To be honest, I am not a supporter of such a trading strategy. But since I trust my friend's honesty more than his strategy, I'm willing to invest with him.
Diversify your masters
If someone promises you that you will earn money every day, week or month, run away. No trading strategy works all the time as market conditions are constantly changing.
The only way a trading strategy is consistently profitable is if market conditions do not change, which is impossible. Therefore, you can use multiple inconsistent trading strategies and smooth out profits over time.
Momentum trading in stocks works well in bull markets, but over time it suffers a drawdown when the market turns bearish. You can use an uncorrelated trading strategy, which usually works well during times of crisis.
Aim to copy trades from different masters with different trading strategies so that you can improve your returns and diversify your risks.
Find traders who are truly interested in profits
There are 2 identical businesses (A and B) that sell vacuum cleaners. Business Owner A has invested 50% of his fortune in the business. Business owner B has invested 5% of his wealth in the business. What business would you like to invest in? Obviously in case A. Why?
Because there is more at stake. In other words, the business owner is likely to do the right thing because he does not want to put his investment at risk, which is also in the interests of shareholders. What's up with copying trades?
You should find traders who use a decent amount of their capital in their trading because they will be looking to make consistent profits.
Summing up
Copying trades allows you to follow another trader's trades. You should be aware of things like transaction costs and commissions, possible conflicts of interest and how you should not be afraid of possible drawdowns.
However, if you want to go down the path of copy trading, here are some tips to help you:
- You must understand the concept of a trading strategy in order not to give up after a few losing trades.
- You must be confident in the person whose trades you are copying.
- You must diversify different trading strategies in order to increase your return relative to your risk.
- You must find traders who are interested in this so that there is no conflict of interest.