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Remotely copying trades of another person is quite popular, and has given rise to ‘Social Trading’. Some brokers promote it like “you can now sit in the comfort of your home without having much market knowledge, and copy another trader and if the trader makes a win, you also make a win.”
This sounds too good to be true & actually is, as there are many risks involved.
Copy Trading is regulated in the UK. The Financial Conduct Authority (FCA) regulates the Capital Market in the UK and classifies automated copy trading as portfolio or investment management. This means that master traders who you copy have to be regulated by the FCA.
However manual copy trading isn’t seen as portfolio management, since you get to make the decisions to implement the signals or not.
Portfolios are now people based as rather than investing in the market, people now invest in other investors. Some experts have also criticized copy trading as creating zombie traders who cannot think for themselves, while others praise it for encouraging everybody to participate in the markets.
Whatever the case maybe we will discuss the risks associated with copy trading & why you should avoid it.
What is Copy Trading?
Copy trading is simply linking your account to a master traders account and copying trades he/she carries out via a CFD Trading platform. Copy trading can be manual, where you use a do-it-yourself approach, or automated where the trades placed by the ‘Master Trader’ are automatically copied in your Trading account.
You and the ‘master trader’ don’t necessarily have to be using the same broker, as you can connect your accounts together via third-party platforms; however, most brokers say it is ideal if both of you use the same broker.
You and the master trader don’t have to have the same amount of capital, because any trade he opens is replicated in your account in the same proportion. This means if the master uses 2% of his equity to open a trade, your account will also be depleted by 2% of equity.
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Risks associated with Copy Trading
1. Exposure to Signal Selling Scams
Social trading has two arms: Copy trading and signal selling.
When you are a member of a social trading platform, you interact with other traders, some of whom have ulterior motives. Some of them sell fake trading signals on the black market, and they could convince you to pay for it.
The FCA recently won a case against 24HR trading academy who were selling signals illegally, and directing clients to sign up with ”partnered brokers” in return for financial kickbacks.
Their action was interpreted by the law as “offering unlawful investment advice” and in contravention of the Financial Services & Markets Act (FSMA) 2000. The court ordered 24HR trading academy to pay back £530,000 with interest, for giving consumers unauthorized investment advice through WhatsApp social media.
As seen in the FSMA Act 2000 : “any person who does any act or engages in any course of conduct which creates a false or misleading impression as to the market in or the price or value of any relevant investments is guilty of an offence if he does so for the purpose of creating that impression and of thereby inducing another person to acquire, dispose of, subscribe for or underwrite those investments or to refrain from doing so or to exercise, or refrain from exercising any rights conferred by those investments”
The point here is that lots of actors on social trading platforms could be scammers.
If you go around buying signals from people who are not licensed by the FCA, you will not be protected by the ombudsman. You will also not qualify for compensation from the Financial Services Compensation Scheme (FSCS) if you are scammed.
2. API Hacking
An API creates a communication link between two Apps that enables them to talk to each other. APIs applied in online trading enable your trading App to connect with a copy trading platform for the following purposes:
- Extraction of data such as real-time price quotes
- Extending functionality such as enabling the trader you’re copying to manage your account or automatically place their orders in your account
Research has shown that after analyzing 21.1 billion application requests, about 70% of these requests were API based. The research also showed that 80% of blocked application attacks were aimed at APIs, and noted that recently there has been a huge uptick (62%) in account takeovers via login APIs.
APIs authenticate the application calling its endpoint, but do not authenticate the individual. API keys which are like passwords can be easily stolen, and can be used until you regenerate a new key so this is a major window hackers take advantage of.
If hackers are able to access an API or the device of the trade you are copying, it could result in:
- Account Takeover
- Credit card fraud
- Fake account creation
- Denial of service
- Man in the middle attack
- API security breach
- Scraping of your data
- Excessive data exposure
The exposure to this risk will depend on the security of your copy trading platform & the security practice of the ‘master trader’.
3. Market Risk
Master traders always have a minimum capital requirement before you can copy them. Once you meet this minimum requirement, copying can commence but most times the master trader’s equity could be far above your own. This means that proportional losses could affect you more and wipe out your capital when the market moves against him.
Example, if your equity is $100 and the master trader’s equity is $100,000 should the market move against the master trader by 20%, he loses $20,000 but you lose $20. You will have $80 left, which in some cases is barely enough to open new positions and pay for any fees and commissions that might have accrued.
You might panic and close the copy relationship, while the master trader goes on to weather the storm and record a profit for himself in the end due to higher risk appetite.
The point here is that there is no guarantee that you would make profits & the trader you are copying could claim that his strategy works but not for your risk level.
Infact, as per the data on this list of forex brokers in the UK, as high as 82% of traders lose their money at forex & CFD trading platforms. This list includes some prominent Copy Trading platforms like eToro.
Copy Trading does not reduce or protect you against market risks. Infact, the use of excessive leverage at CFD platforms exposes you to higher risk.
4. Difficulty in finding the ‘Right’ Trader to copy
This is a major issue because even if you look at a master trader’s statistics and he has been winning, it is still not guaranteed to last. He could just be at his peak and may be about to start experiencing a losing streak.
Some master traders offer strategies that look good on paper when tested against historical data, but don’t work as well in real life. You also need to copy a master trader that uses leverage that suits you because you don’t determine the leverage.
5. Difficulty in Diversifying
Every master trader has their niche or specialty. Some focus on Tech stock such as Apple, some focus on ETFs, and some on Forex etc.
When you finally find the right trader, there is a tendency to want to invest heavily in him. If he/she specializes in Tech company stocks it means you allocate huge resources to tech. This means you are not diversified because if tech stocks underperform, you record huge losses.
However, if you copy several master traders with different niches, it is better but the problem is finding them can be difficult. But that too does not guarantee that you will make money.
6. Conflict of Interest
Every master trader has a profile that shows indices such as his ‘Return on Investment (ROI)’, and the amount he has in assets under management. This is meant to show how profitable he is and give him a higher social ranking in the copy trading community as well as attract more subscribers like yourself.
To maintain this win rate some master traders could resort to “black hat tactics” such as: setting stop losses way below the current asset price, and setting take profits slightly above the current price of the asset.
What this means is that you only get little profits, as the master will not wait for the price of the asset to climb up appreciably before taking profit. He is more interested in quantity and not quality.
He could also set his stop loss far below the current asset price because he doesn’t want to record too many losses as this will affect his win rate. Some Copy trading platforms have a way of monitoring such behavior but most times it goes unnoticed.
7. Liquidity Risk
If the master trader is trading in illiquid asset classes and begins to experience losses, you might want to close the trade manually.
Closing the trade means performing a reverse trade, which could mean selling off the asset class. If the asset class is illiquid, finding a buyer quickly might pose a problem.
Some copy trading brokers allow you to set automated “copy stop loss” to handle this but if the asset class is illiquid, the stop loss will not be able to execute the market order immediately. You risk the asset price falling further before you sell it off to close the copy relationship. This can cause more losses.
8. Time Zone differences
You need to monitor your trades from time to time to see how the master trader is doing, so you can close the copy relationship where you think he is making a loss or where you feel he is taking on too much risk.
However, this might be difficult when you and the master traders are in different time zones.
If you’re in London and the master is in Canberra, Australia; London is 9 hours behind Canberra. This means when it’s 9 am in the morning in Canberra, it will be 12 midnight in London and you might be asleep. This will affect your ability to monitor the trades.
9. Mechanical Failure & Technical Risks
You need to be monitoring your system constantly, even when you are copy trading automatically. This is because technical issues such as power outage or network failure may arise. You need to be there to resolve it ASAP.
If your internet connection is interrupted, it could affect trade execution as the master trader’s trade might not be copied to your account, and this can offset his trading strategy and can result in losses.
A loss of internet connectivity could also mean your trade order will be in suspense and not sent to the market, and sometimes connectivity issues can result in duplicate orders.
There are so many other technical risks which you could run into.
The point here is that copy trading needs constant monitoring as network glitches, etc. could arise anytime.
Copy trading is a part of social trading and is often meant for traders who are either new or ‘too busy’ to trade for themselves. This class of traders are always seen as easy prey for scammers, so there is a need to be careful when on social trading platforms.
There is also a lot of manipulation in the background as every master trader wants to stay on top by all means; even at the expense of those following him.
Before copying, always investigate a master trader, the FCA states he must be authorized to provide investment management for auto copy trading. Also check his strategy and his monthly return to see if he is taking on too much risk.