What is social trading - How does it work
Social Trading Concept
Social trading is about being able to see and copy other traders’ actions, such as open trades and market trading tips. The most famous social trading platform is provided by the eToro CFD broker. In most cases the process can be fully automated, you can simply put your trading account on autopilot, and it will simply follow the trading actions of the provider.
This sounds good and nice, but in practice is very difficult to find winning traders to follow. Most winning traders are either good and hard to follow. Or they are easy to follow but their success does not last too long. eToro is much better than other similar services, as it offers many more markets, not just forex. Also with eToro the motives are better for provider traders to trade more carefully and more selectively. eToro system takes into account many more factors such as correlations among currency pairs, and cross margining.
So it is actually difficult, but not impossible to find good signal providers at eToro and to follow them profitably. It has been proven that you can make 30% per year doing this. So I would think social trading is good, and it can be explored further.
To this day, social trading seems to work relatively well, though followers don’t fully trust their providers, so they don’t use large trading accounts for this purpose. There is mistrust in social trading, and followers are very demanding. They all want to follow the typical day trader who has ultra low drawdown, possibly under 10%, and makes few small profitable trades every day.
I am not against social trading myself, it’s just that I do feel it’s not the best way to evaluate the markets, because you have to rely on the provider. And the provider thinks very differently than you do. If I had to use social trading however, I would use some provider at etoro, a provider offering slow trading signals on some commodity or forex pair, looking to make at least 100 pips per trade. And I would be okay with up to 30% drawdown. Unlike to what most followers demand, a higher drawdown is essential in order to maintain a good strategy. It’s also essential to have losing trades. Providers who seem to be too perfect, tend to lead to surprise failures and to sudden excessive drawdown, such as going from a 10% drawdown to 70%! I would be okay with losing trades, and I would like to see at least 10% losing trades. This is the only way to ensure trading strategy stability.
Where Social Trading Fails
Social trading cannot make you big money, because it’s very difficult to find good providers that you can actually follow and make big money from. For example, you will find some top 5 traders with very good trading results. But when you follow all 5, you may end up in a situation where these 5 top traders disagree on the same market, and they start trading in opposite or nearly exact opposite directions, though with different timing each.
And here’s the big catch! You may think that diversification is good, and that following many providers is safer than following just one or two. But it’s a fact of economic theory that as diversification tends to maximum, profitability tends to zero! This is a fact in portfolio management, and it happens because too much diversification leads to opposing trades, money mismanagement and poor overall strategy. If I were to do social trading, I would follow no more than 3 providers, in 3 totally separate, non correlated markets. Try following 10 providers, and you will get nowhere.
Diversification is a trap for all traders and investors, not just for social trading users. In many investments and markets, traders fail to analyze risks properly and end up offsetting true profitability through excessive diversification. You should diversify your markets in terms of risk appetite, US dollar risk, and other metrics, and use no more than 3 to 5 markets. The key is to use correlations wisely, or to make it simpler, use only 1 or 2 markets, and leave out all correlation patterns. In the forex market, the EURCHF currency pair is an example of a risk appetite currency pair. The Euro is a risk asset, whereas the Swiss Franc is a safe haven type of asset. It’s not perfect but it works well enough for me. So you should check your social trading against investor risk appetite as well, and be critical of your providers’ open trades. You may spot some risk they don’t see. If at risk, you can hedge it through a trade in EURCHF, provided you know how to trade this currency pair accordingly.
In other cases you will see a lot of day trading action which tends to fail, more often than not. But it ends up failing after a while, not right away. This is because followers demand to see ultra low drawdown, and steady profitability. And that’s what some providers seem to offer, for weeks at a time. Until the market changes and their trading system no longer works.
Another big problem of social trading is that it deskills followers and prevents them from ever becoming real traders themselves. Since they end up become passive followers, which in my opinion is not the best way to make money. You may be able to make a lot of money in social trading. The question is whether or not you will be able to think for yourself when you move on to your next investment, relying on third party opinion too much, is not a good idea. You have at some point to think for yourself, and to think originally. And this means you have to question all kinds of experts.
Basic Tips on Social Trading
In my opinion, I believe that you can make the most out of social trading, especially at eToro, by choosing suitable markets, ideally markets that are independent of one another (no correlations exist), and by choosing traders carefully. These traders should trade frequently, at least twice per week, but not be exclusively day traders. Higher frequency of trading, even if it comes from robots, or semi automated trading, it can yield the best results. But the average trade has to be around 30 pips.
Be sure to select providers having long trading history, ideally more than 6 months. A 12 month average trading history is always better than a super profitable 3 month trading history. That’s the way markets work, market dynamics keep on changing and you need to see them over at least 6 months.
Ideally, look to trade CFDs and a whole range of markets, few assets at a time. And not forex all year long, because forex cannot offer you the full spectrum of trading opportunities. Ideally you will want to find specialist providers, one for trading some precious metal, one for trading EURUSD etc. And follow these providers alone. You can expand further by following one day trader and one swing trader, on the same market.
Many people turn to social trading because they want to day trade the markets, but they have day jobs to attend to and cannot afford the time required. These people do profit from social trading, though not very much. The strategies used by providers are rather simple directional strategies, where risk is not hedged. Directional strategies may work well with some commodities and currencies, but only a handful of such providers exist. I would argue that you can probably make more money by following a provider on commodity trading, or some other market that they are an expert in. Specialist traders trade one market only, and actually make millions from it. Whether they are found in social trading or not, is another question, but they would be the best providers ever.
The biggest failures of strategies that I have seen in social trading were unbelievable. I have seen providers ranking as number one for months, having many followers. Providers who made a lot of money in the short term, only to completely fail in a single week later on. And they never recovered. I do believe that crowd opinion can be wrong in social trading. So be sure to judge providers not based on popularity, but on metrics such as trading history, and the way the provider trades. Crowd opinion may prove to be wise, only in platforms provided by blockchains, where the opinion is formed through a prediction market. eToro may possibly utilize this new concept later. For now, just know that even the best providers can fail, because market volatility is so unpredictable.
Finally, if you want to use social trading just to validate and confirm your own strategy and your own trades, then social trading can help you big time! You can compare your trades against the top providers’ trades. You should be ready to challenge their opinion and their timing, even on the profitable trades. This will help you judge the market better and become a better trader yourself, one active trader who thinks outside the box… In this regard, social trading will really help you improve, as opposed to being a passive follower trader all the time.