The Concept of Social Trading
Social trading is a concept where less experienced traders can copy the trades of more experienced traders, usually within the confines of a social network. This means that unlike the Copy Trading system where trades are simply copied without any human input, there is actually a level of social interaction which follows the replication of trades from the Copied Traders.
The lack of full automation of this process exposes the Copier to a variety of risks. Some of these risks will be identified below.
Social Trading: Where the Risk Lies
Forex trading is a risky venture, and the fact that trades are executed using direction from other traders does not reduce that risk. There are several levels of risk in social trading.
- Copied Trader selection
- Application of risk management settings
- Allocation of capital
- Monitoring of Performance
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Here is an explanation of how these factors create risk in social trading.
1. Copied Trader Selection
The structure of the social trading network places the onus of selecting the experienced traders to work with solely in the hands of the copier. This in itself harbours a lot of risk, when considering the fact that those who do the copying of trades in the social network are novices or inexperienced traders. So the question is: how can traders with little or no experience in the market know how to select the traders whose trades are to deliver profits for them in a safe manner?
Many of these novice traders have no knowledge of how to interpret the metrics for Copied Trader selection. They also lack the application of the knowledge gained from interpretation of the selection parameters. This without a doubt, is a source of risk for social traders on the copying end of the equation.
2. Application of risk management settings
After selecting a trader to follow and copy, it is essential to apply the risk management settings that are appropriate for the account. Copied Traders do not necessarily have the same account parameters as all traders following them. Therefore, there is definitely some level of risk in not adjusting the risk management parameters to ensure risk is allocated appropriately.
3. Allocation of capital
Proper allocation of capital is a consequence of proper risk management settings. It is essential to allocate capital according to acceptable risk management protocols to ensure protection of capital in the event of losing runs. Without allocation of capital in an appropriate manner, an acceptable level of risk can be assumed and this could spell disaster for the trader.
4. Performance Monitoring
It is not enough to simply select a trader to follow and leave it at that. It is essential to continue to monitor the performance of any traders followed so as to ensure that the profits keep coming in. Again, if newbie traders have problems understanding how to use the performance metrics to evaluate traders whose trades they follow, then there will be problems and undue risk will come up.
Reducing Risk in Social Trading
So now that the risks in social trading have been identified, how can traders go about the task of reducing the risks inherent in social trading? These are the steps to be taken:
1. Proper Risk Management
There is a reason why we keep harping on risk management. It cannot be overemphasized. The most important factor in trading is ability to ensure that you are not in a position where a loss or sequence of losses will prove to be devastating. Being “all in” in a social trading venture is not the way to go about things. Forex trading or binary option trading involves an element of risk. When you hand over your account to a Leader trader, you are putting the entire fate of your account on another person who essentially has not stake in your money. Without the trader having a vested interest or sharing in your risk, the risk factor involved rises.
It is therefore essential that your selection of Leader to follow be based on sound principles of risk management. Some social trading platforms have evolved a system of assigning a score to the risk factor called a Risk Score. It goes by other names as well. As much as possible, choose traders who have a low risk score.
2. Know How to Select Good Leader Traders
As a Follower, one skill you must master is how to select good traders to act as the Leaders to follow. Social trading is not a “set and forget” forex trading or binary options trading scheme. You must keep evaluating any traders you select for as long as it takes. A trader may deliver great trade alerts for months on end, and then suddenly peter off, thus falling out of the Leaderboard. If you have the skill to know how to select new Leaders to replace them, then you are good. But if you don’t have the skill and you probably relied on some person’s earlier recommendation to choose the Leader about to be replaced, then you are out of luck. You must study how to use the performance metrics to select new Leaders. This is one way of reducing risk in social trading.
3. Correct Capital Allocation
Following a Leader trader on a social trading network will require you to allocate a portion of your capital to this. For every trader that you follow, you will be required to allocate a portion of your capital. This also brings on an element of risk. If you commit too much of your capital to a certain trader who seems to have brilliant stats, you may be in for a surprise if that trader starts to falter. An approach that may work well is to ensure that you first commit as little as 3% of your entire capital to the social trading exercise, and spread this 3% across several traders that you have selected. Watch the performance of these traders for a period of 3months, after which you can re-allocate the capital to the best performers in the group.
4. Portfolio Diversification
Perhaps a little known aspect of social trading is the ability to diversify the asset portfolio to which your capital is exposed. The entrance of cryptocurrencies such as Ethereum and Bitcoin into trading platforms has boosted the asset base on which social trading can be conducted. Rather than expose your capital to traders who only trade forex, you may decide to select traders who trade commodities or cryptocurrencies as well to give your portfolio a good spread.
Being able to reduce risk in social trading requires an understanding of the risk factors in forex social trading as well as the methodology for mitigating those risks. Social trading is not a one-stop panacea for all problems in forex trading or binary options trading, but it can serve as a means of improving trade outcomes for traders who have not been doing well in trading. All it takes is the ability to reduce risk and being able to harness the best that the system has to offer.