A Little Bit of History
The internet has been a great leveller and no more so than in the realm of finance. Many haven’t noticed just how much the financial markets have been transformed in the last few years – both with the move to fully electronic trading as well as the internet opening up access to the wider public.
In the early years, access to the markets was almost exclusively the territory of large financial institutions and wealthy clients. Even if you’d wanted to trade forex, stocks or bonds for example, access to the market was so exclusive and restricted in those days you’d have needed your own broker.
Today, not only can you trade with a few dollars, you can trade using other people’s time, other people’s strategies, and other people’s experience. That’s what eToro’s copy trading is about.
In the olden days before the web Buying or selling any financial instrument involved telephoning your broker and speaking to them in person. They in turn would call their representative trader on the floor of the exchange or a market maker who’d execute the trade on your behalf.
The whole process could take anything from a few minutes to a few days (depending how reactive and available your broker was).
Not surprisingly, for private investors, dealing in this way was very expensive, time consuming and not without risks. In those days, the idea of day trading the markets with a few dollars was unimaginable.
Because of the manual process involved, brokers were only interested in dealing with clients holding accounts worth millions of dollars.
Social investing means you can trade using other people’s time, other people’s strategies, and other people’s experience. In other words, you can have your own team of traders working for you. Not only that, they are working for you for free. How is that possible? With a copy trading. I’ll explain using eToro’s system as an example. But there are plenty of alternatives to choose from.
How Does Copy Trading Work?
Before I get into copy trading per se, a bit about eToro the company. eToro is an online broker, but not a conventional one. eToro offers what they describe as a “social trading platform” (read the full review here). eToro’s open book network (profile pages) means that the portfolio and trade history of every trader is available for all to see on their profile page. If you think, Facebook for traders, you’re not far from the mark.
While everyone’s portfolio details and statistics are openly displayed, the exact dollar amounts invested are not. If you invest in eToro, nobody will ever know how much your account is worth – unless you tell them.
eToro have now taken this idea a step further: On the profile page of every trader, there are two actions that you can choose. Follow or Copy. If you follow a trader, you’ll receive any updates, and details of each and every trade he or she does – a bit like Twitter updates.
If you choose copy, you will automatically copy, like for like, every trade executed on their account.
Let’s consider an example
We always test out several scenarios: When you choose to copy a trader, you’ll be asked to specify an amount to allocate to them. Say for example you choose to allocate $1,000 to trader Bob. This means that initially trader Bob has at his disposal, $1,000 of your equity.
Say Bob executes a trade worth 10% of his equity. When this happens, the same trade will be instantaneously executed in your account for 10% of the copy amount $1,000; that is $100. Everything happens automatically and transparently – both for you and Bob. When Bob closes his position, yours will also close and you’ll realize proportionally, the same profit or loss that Bob does.
Just like when you buy units in a mutual fund or a PAMM account, the amount allocated to trader Bob will increase if he makes a profit. So say after a few weeks he turns a profit of 50%, the amount allocated to him increases to $1,500. Of course, if he made a loss, the amount would reduce.
One drawback is that you have no way of knowing how much of their own money a trader is playing with.
Copying open trades
When you copy a trader, you’ll be asked if you want to copy his or her existing open trades.
Note I advise great caution here. Always review the open trades as well as their full history – if those open trades are all recent, all well and good.
However be wary if there are historical trades (going back several months) with unrealized heavy losses. These are most probably bad positions which the trader entered into in the past and is reluctant to realize the loss on.
The last thing you want is to take on these losing positions. Having lots of unrealized losing trades could also be a sign that the trader is misjudging their entry points – you might want to reconsider copying such a trader.
If you think the positions are recoverable, you can always copy them and take control yourself. This is important since you may be able to manually close with profit, which the trader would be unlikely to do if he mistimed his entry point and is sitting on a large loss.
If you do copy such trades, I advise entering your own stop losses and take profit levels (which will automatically remove the copy).
How To Choose Profitable Traders
With around 2.5 million traders to choose from on eToro, selecting the best can be quite a daunting task. Fortunately, I have some pointers which will help you to select those traders who are most likely to deliver consistent, profitable returns over the long term. Here are the criteria I use:
- Must have at least 12 months trading history
- Must be active (at least 1 trade per week, over the last 12 months)
- Must have a consistent performance with no drawdowns greater than 25%
- Must have an annualized return (realized profit) of at least 25%
- Must be at least 95% manual
- Must have at least 85% win ratio
- No more than 20% high risk trades
There’s a filtering tool provided on the eToro openbook that allows you to screen traders by a whole range of different criteria. In addition the quick settings will take you straight to commonly searched screens, such as high return, low risk. You can apply these settings to any of the given time frames.
Beware: When reviewing a trader, always check their trade history to make sure their performance is consistent. It’s very common on eToro for people to rush in to copy traders just because they’ve achieved astronomical profits of 3-4,000% over a few weeks. In all likelihood, this will have been down to a few small, but highly leveraged trades that went their way (always check their performance chart for smooth, consistent returns).
Remember You have no way of knowing how much of their own money a trader is playing with. For all you know he or she could be using pocket money. In my opinion this is the main drawback of the system (along with the fact that you can’t set stop losses on a trader). If I’m investing my own hard earned cash, I’d at least like to know the trader isn’t just playing for beer money.
Copying copiers It’s entirely possible to copy traders who themselves are copying other people. However, before doing so, always check precisely who they are copying (look in the portfolio section) to make sure you are not duplicating trades by copying the same person more than once.
eToro allows you to copy up to 20 traders at a time. You can allocate up to $50,000 per trader or 20% of your total equity (unless you modify your settings). Naturally you should aim to diversify your portfolio of copy traders. You can also decide the allocations based on your own personal risk/reward appetite. For example, you might want to allocate a higher amount to consistent, but lower profit traders, and a smaller amount to high-risk speculative players.
Does Copy Trading Work?
A lot of the most consistently profitable “traders” on eToro are not trading at all – they are copying other people. In fact, this is one of the advantages. You don’t even need to know anything at all about trading to use this approach. If done correctly you can diversify across markets and strategies.
In this respect, copy trading is like using a managed (mandated) account or investing in a number of funds. If you think about it, the implications of this are far reaching.
Compare for example the process of investing in a managed fund. Typical fees are:
- Manager’s fixed fee
- Front load (placement fee)
- Manager’s performance fee
- Market maker’s spread, for traded funds and structured products
- Secondary fees: Hidden internal trading costs, and taxes depending on the fund domicile
- Your broker’s fee
- Your own local taxes
By the time you see your profit (if you’re lucky), the brokers, tax men, fund managers, market makers, and investment advisors have already taken out their own, very substantial, cut. Apart from the performance fee, they win in any case – regardless of whether you do! Their interests are not fully aligned with yours.
Not only that, many of the top funds only allow purchase or redemptions monthly, some even quarterly. The top hedge funds, and the premier managed accounts typically have minimum investment requirements of $1 million or even as much as $5 million.
In the financial crisis of 2007-8 investors discovered to their dismay that many of these highly paid investment managers where simply not worth their salt. Many funds crashed losing up to 90% of their value.
In a lot of cases, the managers’ performance was far worse than the markets as a whole. In fact, when the crunch came many top paid managers proved to be no better than amateur investors at protecting their clients’ wealth.
Given the alternatives, now and beyond, people then ask why trust your money to a highly paid team of investment managers and middlemen?
Copy trading as an alternative
Copy trading is only as good as those people you select to trade on your behalf. It also means you will need to be more involved with the whole process. However with a small amount of capital needed, low fees and it’s flexibility it makes a good alternative choice for many.
If you compare the above to a copy trading system:
- You have direct access to the market 24×5
- Aside from eToro’s spread, there are no other costs or overheads. Your traders are effectively working for you for free – there are no middlemen involved.
- The traders’ interests are 100% aligned with your own – they are risking their own money on their trading decisions
- You can dynamically re-allocate your portfolio of traders at the click of a mouse
- Realize profit instantaneously, without the risk of waiting weeks or months, in which time the market may move against you
- Open an account with as little as $50
- You can “cherry pick” the best, most profitable traders
- Drop traders who underperform
- With a wide selection of trading styles you can profit in up, down and flat markets
- By choosing a combination of trading styles, you can customize your portfolio to your exact risks/return requirements
- Long/short strategies and the high liquidity and efficiency in forex markets means that market timing is not a critical factor in making an investment. This is not the case with most funds and managed accounts
Is It For You?
For many people, trading is both a means of making money, as well as a challenge. For these people, they may see copy trading as taking the fun away. Though when the system works it can be seen as a new and important alternative to managed investments.
With the rise of “social finance”, what we are seeing is the “tables being turned” in the financial world. Banks and other financial institutions are no longer essential conduits to lending, borrowing and the capital markets. And any system which offers investors a better deal has to be a good thing in my opinion.