Copy Trading: Too Good to Be True?
With the advent of commission-free trading, stocks became accessible to people who never traded before. Copying an experienced trader can make a lot of sense.
I’ve seen traders who allow you to copy their portfolio with annual returns upwards of 50%. These returns seem to be common on social trading platforms like eToro. You would find someone with a 95% annual return with only 2 years of trading experience.
If the stock market, in general, can yield about 12% a year on average since 1928, a 50–100% annual return by an individual trader seems insane. Are these returns even realistic or sustainable?
Learning to trade profitably takes time and money because you will make mistakes. Beginners can be gullible which is why most of them were initially attracted by quick profits of a ‘mooning’ GameStop.
You can find yourself a trading mentor, but a cheaper option is to simply copy an experienced trader. This makes a lot of sense. If copy trading works, this will become a low-effort and cost-efficient side income.
Beware Short-Term Winning Bias
A lot of stocks have grown 100% or more since the pandemic lows in March 2020, so I wouldn’t be too impressed with a trading history of only 2 years.
Traders with a spectacular performance naturally bubble up in eToro’s rankings. The more interesting question is whether traders can sustain such returns year after year. Whoever you decide to copy on eToro could end up being one of the laggards next year. A rising tide lifts all boats, as the saying goes.
We are living in the longest bull run in the history of stock markets. Once this everlasting bull run will come to an end (and no doubt it will), most of the 95% annualized return traders will become the worst performers. It’s unlikely that these traders have learned risk management during those 2 years they’re in operation, and it’s unlikely that they will manage their portfolio well under stressful and adverse circumstances.
Ask About the Strategy and Philosophy
Ask traders what trading strategy they use and how they came up with it. Do they adhere to a systematic approach with proven trading rules, or are trades placed out of gut feel?
Try to understand the strategy enough to feel comfortable copying trades, and evaluate if it can continue to outperform in the future.
In a conversation, a trader may also mention the underlying philosophy of a trading strategy. The more openly they’re willing to formulate their philosophy, the more likely they have intensely dealt with markets.
These are important anchors to help you gain confidence in copying trades. You will need the confidence because cherry-picking trades won’t accurately replicate a trader’s performance.
Beginners who have copied traders before said that they found it good to explore trading styles and to explore their own risk appetite.
Trust Someone With Years of Experience
In the end, you want to trust someone who isn’t just experienced but has a strong character. You’re trusting that a trader works with proven trading rules, runs through solid checklists, and can explain every action taken. You would want someone who can navigate adverse market conditions with confidence.
I was mentored during the 2007/08 market volatility and witnessed first-hand how my mentor sailed through the crisis with ease. It became clear to me that trend trading is the ultimate approach that will perform both in bull markets and bear markets. It works because trend trading is agnostic to which way the market will go. It doesn’t predict.
This is also something I learned from my mentor. If prices are in an uptrend, we will be in a long position. We flip to a short position as soon as the market reverses to a downtrend. This is a powerful concept because you’re no longer at the mercy of the market’s mood. We profit even during market corrections.
Published Thu Sep 09 2021 (last modified Fri Jan 26 2024)