Watch your money management
Firstly, be aware that when you follow a trader, you are mirroring their money management as well as their trades.
If, for example, they risk 5% of their account on a trade, you also risk 5%. This means you are automatically breaking the money management rule of not risking more than 2% on a single trade.
So first check by looking at how much a lead trader is risking before you copy any trades. Some platforms allow you to scale down the positions on the trades that you copy.
Dig deeper into a trader's past performance
Social trading providers usually show a chart of a trader's equity curve or a percentage increase/decrease or their account, so you can quickly scan different traders. Click on the image to the right for an example:
Although a trader's past performance can be a good gauge of their ability, it provides no guarantee of their future results. In some cases, good performance may not even reflect their ability to trade.
Their performance could be the result of one of the following reasons you need to watch for:
1. The Martingale system
The Martingale system involves doubling a position size every time a losing trade occurs. When the trader does eventually win, that winning trade will cancel out any previous losses.
However, for this to work, a trader needs infinite wealth in order to reach the winning trade. It is more likely that the trader will wipe out their account before they win.
To identify a trader who is using a Martingale system, look at their individual trades. You will be able to see if each loss is getting bigger and bigger each time they occur in a row.
2. Survivor bias
Survivor bias is simply opening a number of accounts and trading a different strategy on each. By default, one will out-perform the others and 'survive'. However, because you will not know that all these different accounts – most of them losing – belong to the same person, the one wnning account will give the impression that the lead trader is a successful trader.
Anyone choosing a lead trader may base their decision to follow that trader purely on that top-performing account, not being aware that the same trader has produced less impressive profits or even losses on other accounts.
3. Performance based only on closed trades
The first thing that a follow trader is likely to see is the lead trader's equity curve or percentage increase on their account.
The problem is that most performance charts only take into account trades that have actually been closed. They do not include any trades that are still open, regardless of whether they are currently in profit or loss.
Find any open positions a lead trader has and include them in your own calculations of how well that trader is really doing.
Don't put all your eggs in one basket
When you choose a trader to follow, you are actually investing your money in that trader's performance, just as you might choose a fund or a company to invest in.
Build a 'portfolio' of traders to follow, as relying on a single trader can make you dependent on them.
Don't switch too soon
Even successful traders go through periods of making a loss – sometimes for just a few trades, sometimes for a few days or longer.
Switching or cutting these traders too quickly often means that you get stuck in a cycle of dropping lead traders before you get the benefit of their winning streaks. If they have not changed the way they behave and seem to be following the same rules, then you do not want to cut them too quickly – just going into a drawdown period is not enough.
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