The pros and cons of social trading

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Updated: 19 March 2020

New CFD traders have a lot to learn, including technical analysis,  trading discipline, risk management and fundamental analysis. It is not surprising, therefore, that many inexperienced traders are fascinated by the idea of social trading, also known as copy trading. It certainly gives new traders the feeling of having a safety net when they begin to learn CFDs.

Software that allows new or less experienced traders to “copy” the trades of other successful traders helps facilitate social trading. They enter positions the same way, exit the same way and theoretically make the same profits. There are already several popular social trading platforms, and more are likely to emerge over time, so what exactly are the pros and cons of social trading?

Advantages of social trading

Collective knowledge

Social trading allows beginning traders to crowdsource the knowledge, strategy and wisdom needed to make successful trades. It is not a substitute for learning to trade independently, but it is yet another tool that can help you with that learning curve. New traders always strive to learn techniques and strategies from old hands in trading. Today’s technology makes it possible for them to achieve this via using software rather than purely by observation.

Accessible information from multiple sources

The platforms that have developed social trading software have condensed a lot of information into apps and tools that are easy to access and use. The platforms store large quantities of data from many different traders. While in the analogue age, a young trader was lucky to find one good mentor, he or she can now access many at once, albeit without a personal touch.

Confidence building

Social trading can be a great way to build confidence. This is not an infallible system, and it is certainly possible to lose money, but the probability of making successful trades can increase with copy trading. Copying successful traders can also serve as a reminder that everybody loses money on some trades, often with planned, strategic loss-taking, so it can provide new traders with the confidence of knowing that this is normal and not a sign that they are failures. Some hobby traders will stick with social trading long term, but many new traders will use it to gain the confidence needed to go out on their own.

If social trading is so easy to access and allows you to simply copy the trades of more successful traders, then why isn’t everyone doing it?  There are good reasons why serious traders want to learn to trade for themselves, and there are also some reasons why, in practice, social trading may not live up to its promises. It is not unusual for social traders to lose money overall even though they are copying traders who are supposed to be successful. There are a few reasons for this.

Disadvantages of social trading 

False sense of security

Social trading platforms understandably play up the potential gains that traders can make with copy trading. They emphasise that you will be making the same trades as the most successful traders in their network, and the implication and main selling point is that you will make money.

New traders may forget that everybody loses sometimes. They could start copying a trader at the beginning of a winning or losing streak with unrealistic expectations of how much money they can make, and therefore may invest more than they can afford. When they lose that money, they may give up a huge slice of capital, while the trader whom they copied may have lost a much smaller percentage of his or hers.

Overconfidence 

A false sense of security can cause overconfidence, which may lead to traders taking their eyes off the markets in a way that they never would if they were not copy trading. No trading system is truly “set it and forget it,” but this is exactly what some traders expect to be able to do with social trading.

Trading always takes effort. Even if you are copying the trades of a successful trader, there is no guarantee that he or she will continue that success long term. You should always be monitoring the traders whom you are copying. When you copy trade, you may negate the need to learn how to use technical and fundamental analysis, but you should, in fact, be monitoring and analysing the traders whom you imitate. As you monitor their performance in different market conditions, you can refine your strategy and focus on copying the traders who do well in certain market conditions while they exist and change tactics as the market changes.

Differing trading conditions

New traders may be operating under very different conditions than the traders whom they copy. When you copy one set of trading patterns in one market, you have no idea of the circumstances of that trader. He or she may have a highly diversified portfolio of investments and may be using, for example, very high-risk, high-return strategies because their other capital is safe in low-risk investments.

In short, you have no idea what the total capital of the trader whom you are copying is or how diversified it is. So, you still need to devise your own risk-management strategy, depending on the amount of capital that you have and how diversified your investments are. Poor risk management is a major reason for losses with all types of trading, including copy trading.

Generally speaking, social trading is a fascinating way to begin CFD trading or try trading if you are not sure about the practice. However, you should remember that it is a far-from-perfect system. There is no guarantee that you will make money just because you are copying traders who have done so historically. The best way to trade is invariably to put some time and effort into learning how to develop your own strategies, manage your own risk and make your own trades.