Copy trading is popular with traders who lack expertise in a specific market and those who have limited time to commit to trading. Here is how to copy trades and the risk involved.
Before you start copy trading, it’s important that you have carried out your own analysis on a position or particular market before you commit real capital to it. Remember that even if you are following the methods of an experienced trader, your capital is still at risk.
CAPEX Academy can help you here, with resources and message boards to bring you up to speed with anything that you feel you could know more about.
We also offer in-platform analyst ratings, alerts, and technical chart indicators. These enable you to receive notifications about how a market is behaving. Our technical indicators will help you to analyze historical price action and make predictions about what might happen to an asset’s price in the future.
What is Copy Trading
Copy trading is a branch of social trading, where one trader’s positions are copied by another trader’s account when they are opened or closed. This can be either automatic or manual – and it’s up to an individual to decide how they would like to approach copy trading.
Social trading focuses more on gaining ideas and insights from different websites and services in order to develop new strategies, share tips and invest in tools. Copy trading is more focused on replicating trades and attempting to profit from the results only.
Copy trading was born out of mirror trading in 2005. Initially, traders copied specific algorithms that were developed through automated trading.
Developers shared their trading history, allowing others to copy their trading strategies. This scenario formed a social trading network. Eventually, traders began to copy trades in their personal trading accounts, copying another trader rather than a strategy.
Copy trading can be useful for traders who don’t have the time to follow the markets themselves. Generally, copy trading is focused on short-term trading, in particular, day trading and swing trading strategies, but there are several different strategies that are used to generate revenue.
Copy trading tends to focus on assets within the forex market, as well as cryptocurrencies and other complex or volatile markets. While copy trading can be lucrative, there are also risks involved, and traders should remember that past results are not a guarantee of future returns.
Social trading vs. copy trading
Copy trading also shares similarities with social trading. In the case of social trading, investors gain ideas from many different social trading networks. Traders are able to share ideas with each other and develop new strategies, as well as replicate similar strategies and tools, whereas copy traders prefer to replicate exactly the positions of an individual trader and the subsequent results.
Mirror trading vs. copy trading
There are slight differences between copy trading and mirror trading. The definition of mirror trading is mirroring a trading strategy. Traders mimic the trading style or trading strategies of other traders. Initially, traders were interested in specific algorithms that were developed and developers shared their trading history. Traders would find algorithms with strong returns and then copy their results, asking for permission first to access their strategies. Copy trading was born out of mirror trading, but in this case, a trader doesn’t receive the layout of the copy trader’s strategy. Instead, they follow the trader’s trades blindly.
How Copy Trading Works
With Copy Trading the investor has the option to automatically “copy” every operation executed by another trader, in order to replicate his performance on his own personal account.
With a Copy Trading service, the investor does not give his funds in the hands of the fund manager, i.e. the other trader (as happens with the common investment methods).
In this case, the investor simply opens a trading account, which he keeps the property of, and then, via the Copy Trading platform, he connects his account to the designated trader one’s.
In practice, funds are always in the possession of the investor, there is no delivery of money to a third party.
Simply, with Copy Trading the investor delegates the management of his account to another trader (or more than one) from whom he automatically copies the trades.
The main players
What are the essential components at the backbone of Copy Trading?
There are several versions and nuances in the multitude of services offered, but essentially these are the basic components of any Copy Trading service.
Being a financial instrument is obvious that the entire structure is developed on a financial market.
The main market on which Copy Trading was born and grew (due to its immense liquidity) was the Forex Market, i.e. the foreign exchange market.
Another fundamental element is the Forex & CFD Broker, your ever-present companion. You can’t invest in almost any market without it.
With Copy Trading, you need a broker to get a trading account on which to receive, via the Copy Trading platform, the operating signals of the traders you have decided to copy.
The Trader (or Signal Provider)
The Signal Provider is the trader you have decided to copy.
Obviously, you don’t choose which traders to follow sight unseen. Each platform allows you to observe and evaluate various data on the Trader’s operating performance.
There are various modes.
Some platforms require an evaluation of the strategy before allowing it, while others simply record the performance of the Signal Providers from the moment they subscribe, thus creating statistical data records for the users to consult.
The visibility of these data and their depth and accuracy are some of the most important elements for a correct selection of the best traders to follow.
The investor (or follower)
This is, of course, your role.
Copy Trading is very flexible and can be used for many investment methodologies.
Each investor has his own objective and risk tolerance. Your job is to understand how to translate into practical and specific choices these two components: goals and risk management.
The Copy Trading platform
The last component, of course, is the Copy Trading platform, without which this would not be possible obviously.
Before the advent of these platforms, investors who wanted to benefit from the experience of other successful traders were using mailing lists or chat room services, but, clearly, they were not automatic.
As we shall see, there are different types of Copy Trading platforms, each with its own characteristics, and each with its own pros and Cons.
It is up to you to decide which one to choose according to your expectations.
As mentioned before, there are brokers who are Copy Trading platforms themselves (sometimes named “Copy Trader”).
However, for convenience only, to explain the signals replication process, we will refer to the condition in which the brokerage and copy trading services are managed by separate entities.
The Copy Trading platform is primarily concerned with two things with regard to the actual signal replication tasks:
- It acts as an intermediary between the Signal Provider broker and the investor Broker (it’s a broker or brokers).
- It handles the replication and propagation of signals from the signal Providers to the multitude of investors who copy them, according to the particularities of each one.
Imagine you have a $1,000 account, but you want to replicate a signal Provider with a $100,000 account. His hypothetical 1% invested in a new trade is equivalent to your entire capital, and you obviously can’t afford to invest the same amount, otherwise, one losing trade would be enough to burn your account.
For this reason, we need to proportionally replicate the trades of Signal Providers. The Copy Trading platform takes care of this.
Your job is to give them the necessary instructions and decide the settings with which you want to replicate every trader.
- When the Signal Provider opens a new trade, his broker sends the data of the same trade to the Copy Trading platform
- The platform receives the data of the new trade
- The platform verifies who are the investors who are copying the Signal Provider, and the personal replication settings of each
- The platform sends to each investor’s broker the details for the opening of the new trade but modified according to the client's settings
- Each investor’s broker opens the order on its customer’s trading account
And this is all automatic.
And it happens in a few tenths of a second. Same thing for the closure of the trade, or for a change in the Stop or Profit parameters.
The Signal Provider
In Copy Trading you can consider Signal Providers like the assets in your portfolio, and that’s why it’s often called a “People Based Portfolio”.
Each trader has its own characteristics and peculiarities, but there are some common categories under which we can categorize them.
The first category refers to the techniques used for trading, and we have:
Essentially, most of the time a trader specializes in one of these three categories, but he also has a basic understanding of the other two.
We can then group them according to the time horizons in which they operate:
- Long-term Traders (monthly or yearly horizon)
- Swing Trader (daily/weekly horizon)
- Day Trader (hourly/daily horizon)
- Scalper (seconds/minutes horizon)
Then, there are various factors you will need to pay particular attention to, for studying the strategy and the performance of the Signal Providers. Among the most important there are:
- How long he has been trading online
- How many instruments he trades with (is he specialized in one or does he diversify with many?)
- How many positions he usually keeps open simultaneously
- How many trades he executes on average (per day, week, etc.)
- How long he keeps them open on average
- What’s the winning percentage
- What are the Risk/Reward values
Investing in a Copy Trading strategy basically means becoming a fund manager.
The fund is yours, the capital is yours, and the manager is you.
You then have to decide what are the objectives of your fund, what risks you are willing to take, and then look for the best solutions to build it, i.e. the best assets.
In our case, your assets will be precisely the Signal Providers.
Many beginners make the mistake of thinking that the only important thing is finding the right traders and that everything else doesn’t matter.
On the one hand, it is certainly true, but this is not enough.
Think of the above example, the Signal Provider with a $100,000 account and you with $1,000. If you can’t reason properly, you risk burning your account even by following the best traders.
The factors on which you need to focus on and develop as an investor in copy trading are:
- Declaration of (plausible) goals
- Recognition, analysis, and management of risks
- Search and selection of Signal Providers
- Choosing each signals replication setting
- Implementation of the Strategy
- Portfolio management and monitoring
What are the Copy Trading Risks
Copy Trading is a form of investment. And as with any type of investment, you are putting your capital at risk. Anyone who says the opposite, that there are no risks is not in good faith.
Copy trading can result in high profits if the trader finds a successful trader to copy. However, the greatest risk a trader will face when copy trading is market risk. If the strategy a trader is copying is unsuccessful, they can lose money. Traders also face liquidity risk if the instruments they are trading experience illiquid conditions when markets are volatile. Lastly, traders can face systematic risks if the product they are trading experiences sharp declines or rallies.
Market risk describes the risk of loss due to changes in the price of a security. The goal is to generate gains from an increase in the value of the asset being traded. Obviously, there is a risk that the asset will lose value. Traders can protect themselves from market risk beyond what they expect to lose by using an asset allocation strategy. This means that only a certain amount of funds are allocated to a certain strategy. By allocating all their assets to a single trade strategy, a trader could face large losses if an unexpected event occurs, and this could wipe out their entire capital.
Liquidity risk means that one may not be able to exit positions at expected levels. A trading strategy’s risk management method should have historical precedence so the trader can see the copy trader’s maximum historical drawdown. The maximum drawdown shows the peak-to-trough decline during the life of the strategy. This is a very important figure as it lets traders see historically the maximum amount they may be comfortable losing at any given time if they choose to enter the strategy. For example, a copy trader may have a maximum drawdown of 25%. This means that one can expect to lose at least 25% at any point once they start copying the trader.
It is also useful for traders to gather information about the products and asset classes they are trading. This is because each instrument has a different liquidity level. For instance, it will be much easier for a trader to exit positions in EUR/USD, compared to liquidating emerging currency pairs like the Turkish Lira for example. When copying traders that focus on emerging market currencies, you should examine the slippage incorporated into their returns, which can be significant during periods of heightened volatility. One should also ensure that the bid/offer spread of the currency pair or security is not eroding the copy trader’s returns. Is the copy trader incorporating commission costs into their returns? Copy traders that transact often will have elevated costs of trading.
Emerging market currencies are more exposed to systematic risks. This means that one’s money could get locked up and the trader may not be able to exit their positions. This has happened in the past when countries are overthrown and the capital is locked up and forbidden to leave. While this scenario is very rare, it needs to be included in a strategy where this situation could happen, especially in the foreign exchange market.
Here are some other risks you will be present with, and that you will be able to face:
- Not knowing how the platform settings work
- Not recognizing the risks of the Signal Provider’s strategy
- Not knowing how much capital to assign to each Signal Provider
- Not controlling your portfolio
Copy Trading is not an activity that you simply set once, then forget, and you remember only when you want to cash your profit. Obviously, it should not become a full-time job either, as the Signal Provider one, otherwise, it would lose its convenience.
The important thing is to find a balance, in order to constantly monitor the evolution of your fund, and know how to deal with adversities and how to react to them.
Copy trading is a portfolio management strategy where one copies the trades of another trader, tracking the performance of that investor.
Before you start copy trading, you should do your own market research – especially if you are unfamiliar with the way that a particular asset works and the risks of leveraged trading.
Before you start copy trading, you should consider using the educational resources we offer like CAPEX Academy or a demo trading account. CAPEX Academy has lots of free trading courses for you to choose from, and they all tackle a different financial concept or process – like the basics of analyses – to help you to become a better trader or make more-informed investment decisions.
Our demo account is a suitable place for you to learn more about leveraged trading, and you’ll be able to get an intimate understanding of how trading and investing work – as well as what it’s like to trade with leverage – before risking real capital. For this reason, a demo account with us is a great tool for stock investors who are looking to make a transition to leveraged trading.