Strike when the iron is hot
Similarly to any other type of trading, the key to a successful copy trading strategy is knowing when to enter a copy relationship and when to exit it. Just like various financial markets, traders experience upswings and downswings, and you want to make sure to start copying them at the beginning of the former rather than the latter.
So how can you tell what phase a trader is in? There is no way of knowing with full certainty since traders are as unpredictable as the markets they trade in, but there are a few tell-tale signs. A good place to start looking for those signs is in the trader’s list of open trades. A lot of times the stats in a trader’s profile will only reflect their performance based on trades that have been completed but don’t take into account the positions that are currently held. If a trader has a lot of such positions, and especially if many of them are in the red and have been so for a while, barring a sudden market turn around, this trader is heading for a fall. Therefore, there is no use copying them now, but you might want to keep an eye on them in the future, because, after those losing trades will have finally been closed, the trader may be ready for a new upward phase.
Conversely, a trader who’s recently suffered a few draw downs but has a good overall performance record and few open trades is ripe with potential to do well now that their slate has been wiped clean. So remember, a good copy trading strategy involves looking not only at past performance but also at a trader’s current situation, with an eye toward the future.
Know when to let go
Just as important as knowing when to start copying a trader, is knowing when to stop. This can be harder than you might think, because of the various psychological factors involved. In addition to the sunk cost fallacy that plagues every financial trader (the more money you sink into an investment, the harder it becomes to abandon), with copy trading, people tend to become emotionally attached to the traders they copy. And for good reason: most will have had at least some kind of interaction with these traders, perhaps even gotten to know them on a personal level.
Yet to keep copying a trader that is losing you money just doesn’t make sense as a copy trading strategy. Therefore, the only logical move, once the trader gets on a downhill trajectory, is to let them go. A good way to keep checks on yourself and to make sure your loyalty to a trader doesn’t sink your investment is to use the Copy Stop Loss tool that some social trading platforms provide. That way, you predefine just how much money you’re willing to lose on a given copy relationship, and your emotional hang ups won’t get in the way of solid investment management.
Diversity is key
Copy trading may be fundamentally different from traditional market trading, but some things remain true for any financial trading strategy, namely the fact that diversifying your portfolio is the surest way to lower risk and secure long-term profitability. With copy trading, however, achieving diversity may require a bit more research and careful strategizing than traditional market trading, where diversity is pretty much self-evident.
To demonstrate, let’s look at an example of how easily one can end up with an undiversified copy trading portfolio. Let’s say that you’ve started trading with a new social trading platform, and as far as copy trading strategies go, you couldn’t think of anything more original than copying the five traders on the network that have shown the most percentage of gain over the last year. However, once your copy relationships have been established, it turns out that all five of these traders trade exclusively in the EUR/USD market. Thus, even though you’ve ostensibly invested in five different traders, you’ve ended up with a highly unbalanced portfolio, or to use a colloquialism, with all your eggs pretty much in one basket.
To avoid ending up with such a nightmare scenario your copy trading strategy must consist of carefully checking the portfolios of the traders you’re considering copying. The safest way to go is to pick traders whose investments cover a variety of instrument classes - i.e. stocks, indices, currencies, commodities, etc.
Take into account, of course, that traders may change their trading strategies while you are copying them. After all, they are under no obligation to remain consistent in their choices of investments and may choose to branch out into markets that they previously didn’t consider. It is therefore highly recommended to keep a close eye on your copy portfolio as a whole to make sure that no previously “compatible” traders - i.e. traders whose investments create a balanced portfolio - start to clash, or that you don’t become too heavily invested in any one instrument. In such an event, it is advisable to stop copying one of the traders that are throwing the balance of your portfolio out of whack and finding a trader that fits in better with your copy trading strategy.