Social Trading: Caveat Emptor

I wrote about social trading several weeks ago and some readers would like to know my objective take on this trading style. I do not expect that there are so many people interested in the subject. I am posting my first impression here since I have already tried out several brokerages offering the service.

Bottom Line

All the social trading brokerages offer some kind of tracking facilities for their clients to see who are the best performers. All kinds of statistics are computed so that the clients can browse through the top ranking accounts easily. For example, you get to see the top performers based on total percentage gain for their trades, total percentage gain for the accounts, best percentage winners, etc.

The goal, of course, is to have the clients to get excited and read about these top performers. In the process of socializing, the opportunities of the interested crowd to follow the top performers increase. After all, the brokerages can only make more money when the clients all trade more.

Difficulties With Picking Winner

The bad news – it is extremely difficult to identify the good accounts to follow.

The statistical methods used to identify the top performing accounts can tell you only what happened before, but they are not projection tools that can tell you what will happen in the future. Without knowing exactly how those trades happened with the top performing accounts, it will be quite difficult to figure out if one can follow the future trades with confidence that the performance will be close to what happened.

Even long term tracking of an account may not be able to tell you if the performance is stable because it could be a stable environment that fit the strategy used by the account contributing to the success. Adding this to the already difficult task of separating the good traders, the not so good ones but having a lucky streak, and those who trade with a gambling mindset in exchange for the payout from the brokerages (for having followers copy their trades), it is easy to see why it is not a trivial task to pick a winner to follow at all.

The Land Where Contrarian Play May Not Work

I have looked into the bullish / bearish ratio reported by several social trading brokerages on the major pairs in forex and the S&P 500 CFDs. I found that there is no real consistencies in the data they reported against the turning points in the underlying markets.

There is no consistent confirmation bias with the ratios. There is also no consistent contrarian bias with the ratios. In another words, the trading activities within these social trading brokerages do not resemble the behaviour of normal markets.

My guess is that the bullish / bearish ratio reported are affected by the massive number of followers in those markets I analyzed thus you cannot obtain real market sentiment off the reported data. My study of these sentiment data is still in the beginning stage. If I find a way to utilize the information, I will change my opinion in the future.

The Risk Behind Following Bot Traders

Some of the social trading brokerages offer accounts allowing trading bots to drive the trading.

Following bot traders has similar pros and cons like following the human traders. With bot traders, however, it has the advantage of pulling trigger without emotion thus their performance should be more consistent than the human traders. The effect should be more profound in the scalping arena comparing to the swing trading environment. Human traders can become fatigue after trading intensively during hectic market environment. Hence leading to slippage in performance as judgement can be more error-prone than usual.

For long term swing trades, a good trader can often outperform bots by making the proper exception when the environment has changed. Thus an account you track that gains slowly and steadily through long term trades may not be a bad idea at all if the trader behind the account has a lot of experience. That, you have to talk to the person to get to know the trading principles behind and see if that is something you are willing to accept before copying the trades.

Attractive Alternatives For Potential Good Traders

There are definitely talented traders out there. Not everyone talented have seed capital to trade with in the beginning. Those who have the potential in becoming great traders will find social trading a very attractive alternative comparing to trading for a prop firm or raising capital the traditional way. Social trading enables a trader to start with small amount of capital. When the trader gets better over time, a loyal following from the crowd will supplement the trading profit nicely. Think of it as an alternative way to run a fund where you have extreme transparencies into every trade you take.

The catch, however, is that exposing yourselves to public comments on specific trades and strategies can be detrimental to the development of your trading psyche. Once a position is openly discussed, majority of people will find it difficult to not defending their position in place. The act of defending your open position in public can affect your thinking process and reduce your willingness to cut your losses even when the situation no long warrants the trade. This is bad for your trading.

The goal of a trader is to make money. Flipping your opinion is not only allowed, it is actually encouraged when you see signs of danger that can affect your bottom line. Unlike social networking, the interactions with other people in this situation can hurt a trader from developing the proper attitude towards trading.

Interesting Future

I can see social trading becoming something big in the near future as traditional brokerages no longer offer real values to their clients. Brokerage fees are really execution fees nowadays. Many brokerages are too generic and lack the uniqueness to hold onto their clients. Social trading can change all that. Since retail investors have no clues in trading will be happy to find someone they believe in to copy their trades, those brokerages without the social trading service or the talented traders will have a very hard time to survive.

The new competition among the brokerages in social trading will be very interesting.

Would that turn into something similar to TV stations trying to find the next blockbuster TV show?

Or, using the internet metaphor – finding the next youtube sensation?

Just think of the fiasco we heard of about the rock stars or famous writers switching publishers. You probably get the picture.

The star traders among the people will rise to the top as their trading abilities will be real value and driver behind the revenue of the brokerages. Since these traders can command the followers, it will be difficult for the brokerages to keep them if the deals given to these star traders are not good enough. A brokerage cannot force these star traders, after all, being their clients, into contractual obligation to stay with them.

If the brokerages make their deals harsh and unfair in the first place, it will be very difficult for them to recruit future star traders. Their competitors will make sure of that with better deals and perks.

Interesting future indeed.

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