Risk Management in Copy Trading: Protecting Your Capital

In every type of trading, risk management is crucial. This is because a good risk aversion strategy will not only protect you from unforeseen losses but also help you make profits on risky trades. With risk management, traders can enter highly fluctuating markets while safeguarding their capital, gaining experience and earnings at the same time. It is crucial here to notice that risk management can be done for any sort of asset class in whatever trading strategy you are using. 

Some strategies are riskier than others and may require a robust risk management plan. One such strategy is copy trading. In this strategy, young or upcoming traders copy the trades of an experienced trader to gain experience and profits. This means that the trader potentially leaves the fate of their capital in the hands of the trader that they are copying. Copy trading is mainly done through online platforms, and generally, the trader being copied may not have an idea of who is copying their trading strategy bit by bit. This strategy might be profitable, but it is an excellent source of learning and understanding the dynamics of a trading market. 

It is therefore very important that, in copy trading, a suitable and well-planned risk management plan is implemented. This is because a trader should not depend a 100% on the capabilities of the other trader. Due to whatever personal or professional reason, what if the experienced trader decides to take a hit in the market or plans a risky play in the market? There are various reasons why a trader conducting copy trading should consistently enforce risk management techniques. 

There are a few very versatile and easy-to-implement risk mitigation techniques that the traders can use to safeguard their trades and capital. An important thing to remember here is that if trades are being conducted in a highly volatile market, it is wise to adjust your risk management techniques accordingly. In this article, we will take you through everything that you need to know about copy trading risk management techniques and more. 

What is Copy Trading?

Mirroring trades, also known as copy trading, is an investment strategy where a trader copies or mirrors the trades of another, more experienced and acclaimed trader. This strategy appeals to newcomers and beginner investors looking to get exposure in the market and play it safe to minimise losses. This technique allows them to gain valuable insights into how seasoned investors trade and leverage the market to their benefit. 

As more retail investors enter the markets, a rise in the use of copy trading strategies can be seen in the forex and stock markets. This is because traditional self-directed trading is time-consuming and carries a higher risk of losses for new traders and investors. In contrast, stock or forex copy trading requires minimal effort from the trader, making it easier and more time-efficient for beginners than traditional investing. 

Furthermore, copy trading platforms offer many useful metrics, insights, and tools that enable traders to align their investment goals and risk tolerance with experienced and successful traders. This investment strategy, therefore, offers a unique automated approach to traditional independent investing and exclusively managed funds, ultimately providing traders with control and transparency. 

The Importance of Risk Management in Copy Trading

Copy trading is a risky strategy to deploy in trading. Your capital will work on the instructions of another trader and their sentiments. However much experience the trader has, it is wise to have risk management techniques in place and ready to go when needed. Here are a few reasons why risk management is so crucial in copy trading:

Market Fluctuations

Sudden changes in markets, such as the foreign exchange (forex) or futures markets, cannot be anticipated and can result in significant losses. Mirroring traders in such volatile markets can expose beginner traders to additional risk, especially when the whole copy trading process is left to automation. Therefore, it is recommended that the traders diversify their portfolios by mirroring multiple traders who work in various asset classes to minimise the risk of loss due to sudden market shocks. 

Poor Trader Selections

Selecting a trader to mirror is one of the biggest challenges in copy trading. This is because the effectiveness of your mirrored trade will depend on that trader’s experience in the field, trading strategy, risk tolerance, and past performance. There is no guarantee that all trades started by an experienced trader will be profitable, and there is no guarantee that trades started by less experienced traders will result in a loss. Therefore, it is very important that when you select a trader and start copy trading, you start with less capital and do not blindly follow an experienced trader’s path. 

High Leverage

Most copy trading platforms allow high leverage, which means increasing the stakes so that even small market fluctuations can result in significant financial changes, either in the form of profit or loss. To manage risk associated with leverage, new investors should mirror traders who adjust the level of capital allocated to higher-leverage trades or implement conservative leverage strategies, ultimately mitigating leverage risks.

Key Risk Management Strategies for Copy Trading

Here, we explain a few of the key risk management techniques for copy trading and other trading strategies. 

2% Rule

The 2% rule is more of a principle than a strategy. This rule states that a trader should never risk more than 2% of their whole trading account capital on a single trade in the market. Many traders live by this rule, and others think it’s too low of a percentage. In any case, the 2% rule is a good way to start in the trading world and make sure that you are not trading with a risky amount of capital at once. 

3-5-7 Rule

The 3-5-7 rule is a strategy that dictates your risk exposure based on how much confidence you have in the trade. According to the rule, you should take a risk of around 3% on a standard setup, around 5% on a high-probability setup, and around 7% on a highly confident trade. Copy traders can adjust the percentage of this rule by changing their risk exposure to trade confidence ratios. The main thing here is to show consistency and stick to the strategy. 

Stop-Loss Orders

A stop loss order is one of the most effective and widely used risk management techniques. In this technique, orders are placed in advance with the command to sell the position if the price of an asset falls below a certain level. This technique is very versatile and can be used in various ways to minimise losses. 

Diversification

Mirroring various traders instead of just one can significantly decrease the risk of loss. This is because different traders use different insights and trading strategies across various assets and asset classes. In this way, you can avoid being significantly impacted by downturns in any market and guarantee stable returns over time. 

Adjusting Strategies Based on Market Conditions

Most of the time, copy traders leave their portfolios on full automation and only check back occasionally. However, it is best to adjust your strategies based on market conditions and traders to maximise your returns. 

Copy Trading Risks: 3 Hidden Dangers Every Investor Must Know

The following are three dangers of copy trading that every investor must know:

Reliance On a Single “Star Trader” 

When starting in copy trading, most traders rely on the expertise of a single trader. This is not recommended as the best way is to follow a couple of traders and then find the one whose strategy matches your goals the most. Additionally, it is also best to follow traders who trade in different asset classes, so your capital can experience the broader market and profit. 

Platform Downtime

Most of the copy trading is done through online platforms that use servers. During a period of high market volatility or when a large number of trades are being processed, the platform may experience some unexpected downtime. This means that during this period, you might not have access to your account and trades. Regardless of how the market develops, your trades will also follow suit. To avoid such conditions, the best bet is to choose a highly reliable platform and then enforce risk mitigation techniques that work even when you have no access to your account. 

Sudden Market Events

No one can anticipate sudden market events. They can be profitable but also bring you a loss in a short amount of time. This is why risk mitigation techniques are crucial. Everyone knows that an asset might experience fluctuations if there is big industry news coming out or a policy change is expected, but for world economic news and turmoil that cannot be predicted, putting stop-loss orders and position sizing is key for minimising loss. 

How to Evaluate and Select Traders to Copy

The most essential thing while copy trading is to copy a trader who will bring you profit and experience. Finding traders that work well with your financial goals can be tricky and largely depends on your goals. Here are a few metrics you can use to evaluate and select traders to copy. 

Past Performance

This is one of the most important metrics of all time. A trader is known for the trades they performed in the past, including the positions they took, how long they held them, their entry and exit strategies, risk mitigation techniques, and more. Before copying a trader, try to understand their past performance. This will not only help set expectations from the trades but also give you an idea of how their trading mind works. The more experienced the trader, the more you will learn from them. 

Drawdown History 

Evaluating the drawdown history of the trades conducted by a trader can explain a lot about their strategy and trading mindset. They will help you understand how the trader views loss and what their strategy is around it. 

Risk Profile

Finally, evaluate the trader’s risk profile. This will show how reckless or not the trader is and what that will mean for your capital. The risk profile of each trader speaks volumes about their trading strategy and can indicate whether this trader is a good match for your trading goals or not. 

In addition to these three metrics, a trader can be judged on his character and conduct on the floor. Word of mouth is also a great metric to judge the competency of a trader you wish to copy. However, you will fully understand the game once you’re in it with your capital and can then make decisions that work best for you. 

Legal and Regulatory Considerations in Copy Trading

Copy trading is perfectly legal in most countries and is conducted through online platforms. Online platforms have an obligation to maintain order and accountability on their platforms and for all their users. These platforms need to obtain a license from the relevant authorities to conduct online trading. It is now up to the traders to decide which platform they choose and give their personal information and capital to. 

In conclusion, copy trading is an investment strategy where a trader copies or mirrors the trades of another, more experienced and acclaimed trader. This strategy appeals to newcomers and beginner investors looking to get exposure in the market and play it safe to minimise losses. However, complete dependence on another trader is not recommended. So, several risk management techniques should be implemented to protect your capital and profit. 

These techniques include position sizing, following the 2% rule and the 3-5-7% rule, putting stop-loss orders, and diversifying the portfolio. Another critical thing to remember here is that following only one trader is a mistake. The best strategy here is to follow a couple of different traders and see which one works best with your strategy. Also, don’t forget to find traders who trade various asset classes, as this will give you a more diverse learning experience. 

We would like to emphasise that copy trading might be an attractive strategy for many traders, but it is also very risky. Before jumping into copy trading, we suggest trying your hand on a demo account. This will help you understand the market more deeply and assist you in making financial decisions without using any real capital. 

FAQs

Is Copy Trading Legal?

In most countries, copy trading is completely legal and is mainly conducted through online platforms. You will be charged fees specific to each platform. It is most famous among beginner traders looking to gain experience in the market, as well as among passive income traders seeking to make a profit on the side. 

Are There Any Limits on Copy Trading?

There are no minimum or maximum limits on copy trading, so each trader is free to trade as much capital as they want. But we encourage traders always to enforce position sizing and the 2% rule, where possible, to minimise losses. 

Does Pu Prime Allow Copy Trading?

Yes, Pu Prime allows copy trading and is one of the most user-friendly platforms for this type of trading. You will need to make an account and register. After which, you can deposit your capital and mirror trades with ease.