What is Copy Trading and How it Works
We start by answering the two most pertinent questions you might have regarding copy trading:
The first one, “what is this copy trading service that a lot of FX brokers are offering, and how it works?”
And the second most asked question, “is it possible to make money copying more professional, or not, trader’s strategies?”
In short, the answer to the second question is yes. It is possible to make a profit following the trades and strategies of other professional traders, but, with caution and following a series of variables. And that’s the answer to the first question, what is copy trading and how it works?
- Social trading is a new way to trade, by copying the trades of other retail investors
- Copy trading can also be used to learn how to become a better trader
- Always analyse carefully the trading account data of a strategy provider
- For a higher success rate, use your available margin and position size carefully
We will try to explain, in the best and most comprehensible way possible, what is copy trading and what it means to copy other traders. Also, why and when it pays off, the risks involved and how it can become a mistake.
Table of Contents
The revolution on social trading enabled a new type of traders, the copy traders. Social trading gives us the ability to peek at what other traders are doing and then copy the best ones, easy, right?
If only it was that easy. Of course, the idea of copying the strategies of other traders is very attractive, either because you don't have to spend time defining your own Forex strategy, or because you have a sort of guarantee linked to the fact that you choose to copy the traders with the best performance. There are many reasons why you might be inclined to use copy trading.
Social Trading - What is and How it Works
Social trading is a new way to trade, also used in the retail Forex market, by copying the trades of other retail investors. Let's discover more about this new trend and find out its advantages and disadvantages.
Generally speaking, social trading can be defined as the possibility for retail traders to invest funds in a social way, using the most modern communication tools, such as social networks, and via the FX brokers that offer and promote such platforms.
The key for a trader, especially for successful traders, is information, as we all know. We are referring in particular to the information that falls under the concept of fundamental analysis, GDP figures, interest rates decisions, inflation reports, etc.
The sooner a Forex trader can get these important pieces of information, the better. It will allow him precious seconds beforehand to position himself on the market and more easily can predict currency movements.
During the 2010 decade the information technology sector has been characterised by the exponentially growing consumption of information, also thanks to smartphones and tablets.
In the traditional flow of information on which traders base their analysis, Forex social trading offers a new type of information that savvy traders are taking into account, the actions of other traders.
Spotting an emerging market for social trading, eToro was among one of the first Forex brokers to set up a platform for real time information sharing between traders.
Through its trading platform traders can see what other traders are doing in real time, and regarding Forex, what currency pairs they are currently trading, are they long or short, as well see what their results are in terms of profits and losses.
Interesting enough, one of the main features of social trading, and why so many wannabe traders sign up on these platforms, is the ability to copy other people's trading by being able to monitor their activity in real time.
For beginner’s traders there are two main advantages to this way of trading. The first, and maybe most important, is being able to learn from other experienced traders by following what they are doing, open and closed positions, position size, money at risk, in real time.
This allows newcomers a foothold on the FX market education, benefiting them from a unique and free opportunity to learn Forex with more experienced traders.
The second advantage is to be able to invest like the more experienced traders. For example, if you follow a trader who trades well, regularly and is successful over the long term, you may decide to invest some of your capital by copying those trades so that any results achieved are also reflected in your own capital.
This is the principle of copy trading, the positions and decisions that this trader makes will be copied and applied to your account in real time.
Copy Trading - How it Works
Let's start this chapter with tips and tricks on how you can copy more successful traders and try to make some money. The goal could be perhaps to become a better trader yourself.
One of the biggest mistakes beginners can make is to mirror someone’s trading strategy, and trade exactly the same way as the trader you are copying. In this case the mistake is not to consider how the other trader enters the market and how he/she manages the open positions, but instead, you should consider the following about that other trader:
- What is the size of that trader’s account and how much money do you have?
- What risk ratio is that trader taking per trade and what is your risk tolerance?
An interesting fact about copy trading, and when analysing the success rate of top traders in multiple social trading platforms, is that if a trader opens a position, and while it stays open, it will not count in the return ratio.
This means that a trader has closed 4 profitable positions but still has 8 negative positions open, only the closed profitable positions will be counted in the return ratio, and not the negative ones.
Thus, the return rate of a potential trader that you want to copy must always be analysed carefully, by looking at the open/closed ratio and if possible, the historical data of all closed positions. Particularly, check how many positions are open and what these trades are doing.
A Strategy Working for One Trader Could Not Suit You
Didi you find an interesting trader making bucket loads of money and closing most positions in profit? Great, then! But, before you jump in and start copy trading that trader, remember that there’s the possibility that the trading strategy may not work for you.
There are many personal variables that you need to consider in a Forex strategy, chief among, a solid money management plan, including the degree of risk you are willing to take and the investment size you are making.
Then you need to account for whether you are trading predominantly short term, scalping or day trading, or medium to long term on higher time-frames like weekly and monthly.
Do You Get the Same Results as the Trader That You Copy?
Almost, but mainly no. Adding to the reasons illustrated above, another important variable to consider is the timing of the action.
Imagine copying a successful scalper, someone really experienced and successful in fast trading, operating quickly in the market, opening and closing several positions in a matter of minutes. Keeping up with that trader can becomes a real challenge.
From the instant that you see that trader opening a short or long position to the moment you quickly jump to your trading platform, choose the relevant currency pair and try to copy/open that position, up to a minute could pass, during which time you could lose precious pips.
Plus, in the event of extreme volatility due to high impact news releases, maybe while you are still trying to open that position, the trader that you follow has closed his position already.
This is why it is important to always reason about the positions you copy and choose only those that you think will perform best, or avoid all together to copy scalping strategies.
Copy Trading - Risks
Obviously, it’s important to choose carefully the trader to copy because, besides the gains, you will also take the losses.
The main risk is that you will get bitten just because that trader made a wrong call. It can also mean huge loses for your trading account.
Imagine that other trader got hit by a wide stop-loss on a 0.10 lot EUR/USD position on his US$10,000 and he lost 200 pips. A loss of 200 pips on EUR/USD is US$200. That loss represents 2% of his account equity, a risk percentage quite acceptable when trading Forex.
But you are trading with a US$1,000 account and copying his trade on the EUR/USD of 0.10 lot. And that loss of US$200 on your smaller account represents not 2% but a huge 20% loss.
To better understand and familiarise with risk, lot size and pip value we recommend the use of our excellent suit of Forex calculators and tools.
The key to successful and profitable social Forex trading is to choose good traders to copy. Fortunately, the platforms offering copy trading services, free or payable by a monthly fee, are very transparent about the results of their traders. The main platforms providing social, or copy trading, are eToro, MQL, ZuluTrade and Myfxbook.
All the traders with strategy provider status on these platforms are carefully selected. They also need to confirm their real trading accounts connected to a real broker and need to agree in making available all the info about their trading accounts to the public, so you can know precisely all the gains and losses of the traders you want to copy.
Remember, like any kind of investment, you need to diversify. Better not to put all your eggs in one basket, meaning it’s better not to copy just one trader. If you are an inexperienced trader, the wisest thing to do is to divide the funds that you want to invest among several strategy providers.
Even better if the selected traders adopt different strategies among them, like, like medium to long-term trading, and how they manage risk by selecting traders using a lower risk-reward ratio, or a higher R:R ratio.