The Good, the Bad and the Ugly of ‘Copy-trading’

Copy trading is growing in popularity worldwide.

Whether it be in the UK, Europe, the US or even the Middle-East, ‘copy-trading’ is seeing increasing numbers of participants, who are investing increasing amounts of capital, in part egged on by toughening margin conditions imposed by regulators such as the NFA, CFTC, FCA and JFSA in recent years.

Copy-trading is the simple notion of replicating the trades being done by other people, either through automated systems or manually. There are further complications in terms of capital allocated, risk-management, percentage staked on each trade – but the bottom line is trades being generated by a third-party are then simply ‘followed’ with the P&L results also replicated accordingly.

With the advent of the Internet and social-media communication in particular, the rise of copy-trading has been unsurprisingly swift. Entire companies have been built purely catering for clients interested in jumping on the back of successful traders, algorithms and strategies designed by anyone who can wield MQL.

Companies such as ZuluTrade, Etoro, DX and others, cater exclusively for clients that want to cherry-pick the most successful/opportune strategies currently trading the markets – and join them.

As you can imagine, as with any bright idea there can be pitfalls; in this article we try to summarise the major pitfalls to ensure a pleasant copy-trading experience.

The Good

Good examples of copy-trading are those where the trades being ‘copied’ are well-thought out, well risk-managed and appropriately leveraged. Unfortunately, the majority of strategies available for traders to choose from, or traders to follow, are poorly risk-managed and often over-leveraged.

Assuming the trades being copied are being done by a responsible trader/investment firm, then copy-trading can reproduce profitable results for clients that know next to nothing about the markets themselves.

According to a variety of statistics available from around the Internet, and from independent research, over 80% of amateur traders end up losing their entire trading capital within the first 6 months.

Copying professional traders to generate good trading performance can be a quick way to racking up positive returns, but by the same token, markets can surprise everyone including the professionals; so copying their mistakes will cost you too.

The Bad

The ‘bad’ side of copy trading is littered with pitfalls – and its mostly to do with complexity. Internet-powered connectivity has allowed everyone to participate in online-delivered services, including copy-trading.

This effectively means that the Internet is littered with various algorithms (Expert Advisors for MetaTrader users), traders advertising their fund management services, online trading venues etc. With so much choice and accessibility there comes a lot of sub-standard services that are not adequately vetted, regulated or even qualified to offer such services.

The typical pitfall are users offering trading results that look something like this:

The chart above, shows trading performance over the course of 1 year. Many potential investors that see such results are often smitten by their face value and end up forking out thousands to back this strategy.

However, if one looks deeper and reads between the lines; such strategies are often automated and simply trade on the back of ‘Martingale’ thinking. In other words, keep buying (or selling) a particular asset with increasing intensity, until it eventually goes in the direction you hoped it would. This strategy relies on volatility swings reverting back to their long-term averages – considering this type of price action is often seen in FX markets, Martingale strategies have been very successful. However, the downside is that one bad move can spell disaster given the large stakes being taken.

In the chart above, a 45 degree rising profit curve hides the numerous drawdowns as shown by the brief falls. Martingale strategies are tempting to follow because they do work a large portion of the time. However, when they stop working, it usually means 80%+ of your account goes with it.

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