How does the Social Trading Platform work?

In the second half of the nineties, thanks to the emergence of the Internet, the first systems of "online trading" were established, that is, internet platforms that allow their clients to typically buy equity securities, which are the most sought after due to the potential high returns that they can offer.

In Italy, the first platform was Directa SIM, founded in 1996, I know this because two years ago I was invited to the London Stock Exchange to celebrate the company's twentieth anniversary.


These platforms have become very competitive both in the prices offered to clients, often lower than those that an institutional company such as a SICAV pays to the custodian bank and in the technologies used, with the possibility of purchasing directly from the stock charts.

Unfortunately, statistics show that more than ninety percent of Traders, i.e. clients who buy and sell securities via these platforms are not only unable to track market returns in the long term, but they lose money.


Standing alone in front of a terminal can lead to suboptimal behavior, especially due to the inability to understand what is happening and therefore following your own emotions more than reasoning.

In recent years, almost a decade until now, a new phenomenon has been created, known as the "Social Trading Platform", whereby Traders are not only left on their own but are able to communicate and deal with other people and they can also decide to copy other Traders who in the meantime have produced impressive results.


Perhaps the most famous and widely known platform is eToro, a company based in Cyprus that is expanding rapidly throughout the world.

Few people know that eToro actually started off as a retail platform for Forex, like its name explained detailly when it was founded.

But it is not the only one in this field, there are other companies such as CMSTrade, Zulu Trade, Trade360 and others operating in this sector with a high-growth rate.


The ability to share information and opinions is for sure a very interesting attribute, but what attracts many new customers is always the same: the illusion of quick and easy earnings, using leverage and above all, deluding themselves that they are capable of obtaining the best returns (up until that moment obviously ).

According to some articles, eToro has more than 3 million customers worldwide (there are those who say more than 5, but in the platform indicate a generic "millions"), which are nonetheless considerable numbers which testify that the idea is definitely valid and successful.

At least from the eToro point of view, of course.


That's right because the problem is still there, Traders lose money in the long term and the percentages in social trading platforms do not change, just that there are two very dangerous phenomena that have to be taken into account when approaching these platforms:

  1. survivorship bias, i.e. the estimation error due to the fact that only survivors are analyzed, forgetting those who leave the market when making statistics (a phenomenon also present in the world of mutual funds)

  2. Rotation of the winners, i.e. the fact that there are always people who obtain outstanding returns in the short term, just that they are never the same (or almost, just not to generalize) and therefore to an inexperienced eye it seems that it is easy to make stratospheric returns simply by copying the first in the ranking.


Of course, if there were really persistent Traders (and maybe some actually exists) the mechanism would be very sensible, everyone will the best and everyone will earn a lot of money.


But those who know the financial markets are aware that this scenario is pure utopia because if everyone copies the best, his strategy will inevitably significantly reduce returns (if it doesn't become a losing strategy, as explained at the 2009 Quant conference by Yossi Brandes).


Another problem with these platforms is that they work with CFDs or Contract for Difference, which are synthetic derivative instruments designed to allow people to leverage both the long and short on the underlying financial instruments.


The problem with leverage, is that if you use over a certain level (1:2 or 1:3), volatility kills any leveraged portfolio even if it is profitable, this is the harsh truth that many people ignore and these platforms capitalize on.


What is certain is that this business model works and grows at very attractive rates, I have taken the balance sheet of eToro (UK) Limited, which are the only ones that I have found available to the public and free on the web (on the website where you can download the information of all English companies free of charge).

Practically the English company, a Branch of the company authorized in Cyprus, created a few years ago had a 244% increase in turnover from 2015 to 2016; an impressive growth rate.


But then this question arises spontaneously: if most of these platforms don't charge commissions for the buying and selling of CFDs how do they make their turnover? Looking at the balance sheet it can be seen that they have made 77k from trading commissions, 899k from brokering services (i.e. the difference between the price paid by the client and the price paid by the platform) and 912k from not well specified "other commissions", i.e. other types of commission, which in reality are money deposit commissions at an overnight rate, which if you use the leverage obviously multiplies, so for the unsuspecting Trader the platform is not quite as free as he thinks it is.


In conclusion, I personally asked myself a question but is it possible to take the good part of the idea of social trading, but eliminate the Traders who produce unstable results and replace them with asset management experts who do it by profession?

You will have the answer in the coming weeks...


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