Social Trading

In this supplement, David Stevens, explores the growing world of social trading and what it means for the financial services industry.

What is social trading?

Social trading is a new online trend quickly picking up traction across financial markets. While there are just a few operators offering the service, there's a strong likelihood that this movement could very well be the ‘next big thing' in investment markets.

For those unfamiliar, social trading is essentially the people's stock market, where users can follow and even copy the trades of the world's best players. But is this the easy way to play the market, or does the over-democratisation and gamification of the world's financial markets place us at risk of making risky investment decisions?

Until a few years ago, trading on the stock and currency exchanges happened behind closed doors with guru traders, hedge fund managers and brokers demanding huge sums from clients wanting to take advantage of their expertise. This when the majority of so called professionals underperform their benchmark. When you consider that the benchmark itself may be below inflation then this is a sobering thought. There seems to be a belief by some people that investing is very complicated and should be left to professionals - we know this is not the case. But now, with social trading services like Ayondo, anyone can have a hand in playing the markets.

The idea of social trading is built on a few simple principles:

  • Everyone deserves the opportunity to invest in markets without the need for expensive brokerages.
  • Not everyone has the time to monitor real-time market fluctuations.
  • People should have control over what they invest in.
  • Advanced social technology means trading can be democratised and insights easily shared globally

Based on these principles, a few online services are providing the means to allow Joe Public to bypass the world of secretive stock tips and essentially piggy-back on the success of some of the world's most successful traders.

How does it work?

According to WorldFinance.com, social trading works by giving ‘…those with limited financial knowledge an insight into the stock exchange by allowing a real time analysis of individual trader performance. Seen as one of the most significant shifts in trading, social trading has the potential to open up opportunities for those interested in stock markets.' To paraphrase (although hopefully without oversimplifying the concept), imagine Twitter for investors; users create a social trading profile and as they trade, their interactions are broadcast in real-time to their followers. If followers of a particular investor like what they're doing, they can even choose to ‘copy' their trades (like a retweet) with a click of a button, removing what many would see as the painful process of identifying the best performing currencies and commodities and then deciding whether to buy or sell them.

I have a stockbroker, why should I pay attention to social trading?

With as much as $59 Trillion being traded across the top exchanges in 2010, and $4 Trillion worth of trades happening daily on the Foreign Exchange, it's not surprising more and more people want a slice of the pie – and at first glance, social trading provides the means to get stuck in quickly.

Brokers typically charge for their expertise, often as much as $10 per trade. In real-time markets where prices fluctuate in a matter of seconds, this adds up. In social trading, the process of socialising investments essentially democratises the investment process, removing the middle man in the form of a hedge fund manager or broker meaning your pie slice is a little bigger.

Features such as leader boards allow you to see the most successful traders in terms of profit by week, month and year. Making this data public should, in theory, provide insight into the best traders to follow, thereby increasing your earning potential. This gamified approach also instils a sense of aspiration into the service, although, as we'll explore later, this also has the potential to give misleading impressions about sensible trading practice.

Over the next few weeks we'll be looking in more depth about social trading, particularly around the existing pitfalls, the potential opportunities to improve the customer experience and what social trading could learn from online gaming. There'll also be some juicy insights from investment experts about whether these kinds of tools could be the key to market stability, or whether they will inflate the risk of another global recession.

Why would a successful trader share his trades with strangers?

In finance, as in life, imitation is often the sincerest form of flattery. New technology combined with advancements of social trading platforms and online networks today make it even easier than ever for investors to share – and copy – trading ideas. But that is not all. Traders who allow others to copy their trades typically earn a tiny little extra each time someone copies their trades (this is usually built into the technology of the social trading platform). In itself this remuneration isn't much but when a top trader (i.e. signal provider) has hundreds if not thousands of followers this can add up to a healthy extra income each month.

Anyone can become a 'popular investor' on eToro or a 'signal provider' on Ayondo or ZuluTrade if they can convince enough people to copy their trades. Signal providers receive a commission for each trade executed by a live follower account while eToro rewards 'popular investors' based on the number of copiers they rack up.

Social trading: Just another 'get-rich-quick-scheme'?

In the feature above, we explored what social trading is and how the act of ‘following' and ‘copying' the trades differentiates it from other investment options. This next post explores some of the mechanics and potential pitfalls of the system, especially for novice investors, or those expecting a quick return on their investment.

First things first; social trading is not a get-rich-quick scheme. Don't get me wrong; there's nothing stopping you from making some serious money, if you do it right. But investing in stocks and shares is like gambling. Just like when the odds go against the favourite in sports events, the same can happen in investments. Values can fall as well as rise, and the historical performance of stocks, currencies and commodities does not provide a clear indicator of future performance.

Trading can be hard so this is another alternative for people who don't know how to trade – they can simply copy the more experienced traders. It may seem easy to make money copy trading but this is a misconception; you still have to put the time and do your homework including careful risk assessment. Finding traders who know what they are doing isn’t easy and you have to keep watch; unfortunately many of the traders on these trading platforms are out to make a quick buck. Some social trading sites provide incomplete stats so although a trader may look at first instance that's he's successful and making good gains, the underlying data may reveal that he's actually sitting on a number of losing trades that they haven’t closed yet in the hope the trades will reverse.

As a new member of a social trading platform, these realisations raised a few concerns for me:

Am I following bad investors?

In theory, while 'following' and 'copying' other traders should take the pain away from investing, I could end up copying a series of poor investments based on chains of lucky novices.

For example, imagine I am following and copying the trades of Trader Z, who is copying Trader Y, who is copying Trader X. This would be fine if they all knew what they were doing. But what if they're all like me and are just amateurs following other high performers? What if it's a really long chain of people with no trading experience copying each other and getting lucky based on the decisions of, for example, Trader A at the beginning of the chain. Despite the fact she may be an expert, there's a risk that the 'Chinese whisper' effect could get out of control and people are no longer making informed decisions.

Secondly, there is a risk you could simply be following the random dumb luck of a trader who is doing no more than taking a long or short punt, the 50/50 taking a shot. Start off with a large enough group of traders, the larger the better, and some are bound to make a success of it due to nothing more than probability and the way numbers play out. Indeed you only need one who has a particularly good run to attract people.

Could the scale of trading result in manipulated markets?

Another concern was that placing complex market trading in the hands of many novices would exaggerate the effect of global trading behaviour to such an extent it could create a snowball affect across markets, potentially contributing to world economic events on an unprecedented scale. Furthermore, could this be used by rogue traders to alter the effects of market conditions?

Is it focusing too much on short-term success?

Tools like the leader board at first glance are extremely useful in identifying the most successful traders, therefore providing a good indication of people to follow.

As a result, I ended up following people with the highest percentage gains (more than 300% over their initial investment), as indicated by the leader board, thinking I could make good money quickly. Low and behold by Friday last week I had made $150, so carried on in the same vein. But come Monday morning I was $15 down on my initial investment!

My concern is that while the leader board tools highlight the best performers to follow, it makes a game out investing and focuses people on short term gains, rather than promoting good trading practice and helping them see the bigger picture. In fact most people have a tendency to follow the traders with the best short-term performance but this is a mistake - those traders are likely to be using very risky strategies with a high probability that they will eventually blow up their accounts - the ones you should follow are the ones who have the longest track record and who don't trade that often.

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