The flaws in social trading

Social trading has always sounded great on paper as a way for Forex brokers to increase trading volumes, while at the same time encouraging their clients to trade in a more responsible (and profitable) way.

But it hasn’t quite worked out that way.

Yael Warman from Leverate takes a look at what Forex brokers should consider when adding Social Trading functionality.

Instead of having to put in the long yards of studying the financial markets, keeping a constant watch on CNBC financial experts, read the finance section from head to toe and attend every class on BabyPips (though why would you want to miss them?), traders can take a swifter and easier route to success by Social Trading.

Social trading enables traders to collaborate with other investors by sharing mutually beneficial trading information, along with tips and tricks that help people trade more successfully. The format of social trading follows that every group has its “leader” who publishes live trades, allowing “followers” to copy. This creates an opportunity for novice traders to quickly learn and replicate the moves of experienced operators, allowing their profit curve to develop much faster in comparison with other trading formats.

However there are many risks associated with Social Trading. The most striking is that social trading has the means of encouraging new clients to trade more and with larger positions, without developing a proper understanding of how the Forex market operates. Never feeling the need or compulsion to develop any real skill and insight as to how the Forex market works, many novice traders are inclined to rather blindly, following the moves of their leader. Not surprisingly this trend makes this type of trader vulnerable.

Adding concern to this is the challenge for regulation bodies to keep up with innovation. Despite social trading increasingly being picked up as a trading service, financial market authorities are constantly struggling to play catch-up in order to implement additional regulations to enhance the safety and surety of this medium.

Another concern is the ability of the followers to identify the quality of a leader. For a novice trader who does not have a strong understanding of the market and trading, selecting a quality trader will inherently be a challenge. Number of pips gained is just one factor to consider when selecting a follower, with several elements like the length of time the account has been open, trading strategy or average pips per trade being key factors to consider in assessing the value of a social trading leader. A lack of knowledge in this area can expose a follower to a potentially poor trader, with disastrous results.

A key factor to mitigating these risks is by using a regulation-compliant social trading platform that recognizes potential risks and has inbuilt methods to avoid them. Regulation that addresses social trading services, whilst in its nascent stages, is developing and in the process, is being incorporated into quality social trading platforms. In fact, Britain’s Financial Conduct Authority intends to have a regulatory structure for copy trading or social trading with provisions such as having top traders who perform as “leaders” registered as financial advisers.

A regulation compliant social trading platform that will effectively mitigate potential risks could also include the following features.

1. A set limit to risk and exposure

Ideally the trader will be able to do automated “partial” following or incorporation of stop losses to limit risk and exposure. This will ensure that a follower account will not be exposed fully to the leader and maintain the risk level that the follower prefers.

2. Risk Identification

As a leader trades, the system identifies their risk level, based on trades and exposure as well as providing weighting for issues like time traded and fluctuations in balance. For the follower, the software prompts the trader with questions to identify their risk appetite and behavior. These two systems can then be used to help the trader define set levels for risk management or with leader selection.

3. Warnings

An inbuilt warning system could alert traders as they approach their identified risk thresholds or if they are about to perform an activity that entails higher risk than usual.

4. Supervision

As an added layer of protection brokers are required to have a portfolio manager available through the platform. This manager would provide guidance and support to followers for managing their risk and preventing fraud from leaders.

With these protective thresholds in place, the regulation compliant social trading platform does far more than just apply generic protection measures that are copied from statutory regulations and pasted on to the trader in order to prevent risk. Rather, these tools are customized to the individual trader and applied on a real time basis, providing measures specifically adapted for the issues that arise. This enhances their validity, relevance and easy applicability.

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