Social trading and copy trading in particular have become quite popular in the last decade. Nothing seems easier than setting up an account in order to follow the trades of several top experts and the rest is just easy money flowing in, right? Of course some of the signal providers will have a streak of bad luck from time to time but with diversified portfolio what could go wrong?
In fact many things can go wrong. It seems that almost 80% of eToro users are losing real money despite eToro's proclaimed aim to reduce risk in social trading. This number is consistent with another research according to which only 16% of eToro users, who traded at least once during 17 month period, were profitable. I think there are several reasons behind that.
NOTE: The extent to which the following findings apply to each individual social trading platform varies greatly.
In the last post concerning mistakes and biases related to strategy development I mentioned something called survivorship bias. A similar principle can be seen in social trading too: if you have many different random strategies and you run them in a particular market, some of them will be probably profitable by pure chance.
There are people who use similar principle to win investing competitions. They use multiple identities to create several accounts and then they enter long position in one and short position in another in the same market. The balance of losing account gets ruined while the other gets a nice boost. The more accounts they have, the easier it gets to win the competition.
Similarly in certain platforms the signal providers can use multiple accounts to gain followers and collect fees with the most successful one. Or it can be the case that some of the providers are profitable by chance. After all it seems that risk adjusted performance of an average signal provider is worse than buy and hold of S&P 500. Either way you want to completely avoid such providers but with limited information it is easier said than done.
Black Box Solution
When you don't know the development process of a strategy and its inner workings you can't really have confidence in it. You can't possibly know what kind of bias has been introduced during the development. It is also harder to assess if a drawdown is still OK or if you should start worrying. Would you be able to keep following someone else's strategy which had been losing money for a year? Yet this might be nothing more than normal functioning of a successful and well-designed strategy. You can't possibly know without additional information such as the quality level of the development process and/or the backtest results. Last but not least you will never improve your understanding of the markets by blindly copying opaque strategies.
Backtest Curve Fitting
In one platform designed for algorithmic trading I saw the possibility to backtest the strategies on historical data. It would be nice if you could see the inner workings of the algorithms. But with black box strategies the backtest is useless. It is very easy to create a profitable trading system on past data with no real predictive power. It is possible to do that with completely random data too. In such cases the backtest results do not provide any useful information while creating a false sense of security.
When you look at the following equity curve maybe you can see that something is wrong even as the system gives 22% annual return and has profit factor of 1.45.
This kind of equity is typical for martingale trading systems which increase the position size with each loss until they earn the losses back (or go bankrupt completely). If you saw only the part from 2013 to 2014, maybe you wouldn't notice the warning signs. But when you see 2012 too, it becomes obvious that this strategy is something you do not want to follow.
In various social trading platforms you can encounter many strategies like that and they often attract substantial numbers of followers. One of the reasons may be that to an untrained eye the equity curve might look attractive. Also, from my experience, there are many college educated people out there who believe in martingale. Yet another reason that comes to the mind is that the followers don't want to experience long losing periods. With this kind of strategy you are guaranteed to get your losses back quickly or go bankrupt. It's easy to forget the second part when all you see is $$$.
Beware the Unrealized Losses
When judging the equity curve it is important to look not only at the balance of closed trades but at the floating balance of the open trades in the course of time too. If a particular platform doesn't allow to display this type of data it is better to avoid it completely.
Some platforms charge the followers monthly subscription fees while others take a volume-based commission and split it with the provider. If it is the second case check carefully whether these fees are included in signal provider's results either explicitly or in the form of spread. The markets are very competitive and even small differences can make a profitable system useless. There's also a chance that you'll get additional slippage thanks to the delay between signal and your execution and thanks to the number of people who follow the same provider.
Limited Broker Choice
I consider the right choice of a broker to be one of the key elements of success. With social trading platforms the choice is often limited to brokers which offer the best conditions to the platform, not its customers. This is especially troubling in case of Forex where large majority of retail brokers are scammers with inherent conflict of interest.
Most of the above mentioned issues were related to the functioning of the social trading platforms and the signal providers. But the problem lies with their users and followers too.
First, users often lack the knowledge and experience in order to choose the best providers, properly asses risk and set the right money management. If you look at the current Top 10 signal providers on eToro, one of them (with over 23,000 followers) says: "I set stoploss very far so that I don't lose (...) I will wait for the trades to close in profits (...) I know and believe that the pairs will be in green very soon. Till then I will trade with other pairs". She advises her followers to set the stoploss to 95% of the reserved portion of their balance. Does it sound like someone who is worth following? Yet the large number of followers speaks for itself.
Second, people get greedy and are happy to overlook all the warning signs with the image of money flowing in. Doing proper research, which can take months, only slows you, right?
Third, even when they find the right signal providers, it's hard to stick to following them during prolonged periods of losses and uncertainty. One of the reasons is probably the fact that it is difficult to trust a black box solution. Other might be that many people are not prepared for the fact that trading and investing is a long term game, not a get-rich-quick scheme.