Trading Mistakes to Avoid – Following Others

Everyone loves winners, even more so if you can replicate what they’re doing and become a winner too. This is especially true in the world of trading and investing. You can easily view the portfolios of the investor greats like Warren Buffet, Peter Lynch, George Soros or the top holdings of all the major hedge funds, and copy all or some of their holdings. If you want to trade more actively, there are hundreds of traders with chat rooms and groups offering traders the opportunity to follow them into trades. Some (not many) even offer to let you get into the trades ahead of them. In other words, you can follow a winning trader into their actual trade, and be a winning trader too without having to know anything other than how to hit the buy and sell button!

This sounds too good to be true. But is it? There is immense value in being to see what successful, professional traders and investors are doing and there are definitely times and scenarios where you’ll want to copy their trades. The problem arises when you follow someone blindly.

Let’s break down the pros and cons of following other traders, how you can do that successfully, and the pitfalls to avoid if you do decide to follow.

Pros

Learn from the best.

You can learn a tremendous amount from experienced, successful traders who have put their money on the align, as opposed to some professor or academic teaching theories based on historical data and paper trading. Finding a trader willing to teach you and share his or her trades with you could save you tons of money and frustration, and help set you up for a successful trading career of your own.

Watching trade setups and trade management in real time is invaluable, assuming that the trader knows what they’re doing and isn’t just hack trying to make a quick buck off of inexperienced traders. Unfortunately, there are way too many of those trading charlatans claiming to be winners who are in reality either fakes or unscrupulous characters trying to make money off of their followers.

It’s easy to create fake trade confirms or brokerage statements, or to only post winning trades while trashing the losers, or even to pose in front of someone else’s yacht or private jet. That’s why it’s vital to properly vet the traders you’ll be learning from or following to make sure you’re not being scammed. An easy way to know if you’re being taken for a ride is if the trader you’re checking out has no losing trades. The greatest traders have losing trades. It’s part of the game that cannot be avoided. Even the greatest hedge fund kings make bad trades and take huge loses. Remember Gamestop and Melvin Capital’s Gabe Slotkin? Any trader who doesn’t show loses is a fraud.

The ultimate goal of learning from successful traders is to eventually develop your own style and playbook that matches your specific personality, financial goals and account size. As a wise man once said, “Give a man a fish, and you feed him for a day. Teach a man to fish, and you feed him for a lifetime.” If you want to trade for a lifetime, you need to know how to make trades on your own.

Trade Ideas

What better place to get trade ideas from than major investors and hedge funds that have teams of the smartest financial savants working day and night, crunching numbers, developing original research, and poring over charts and reports to find the best trades for their bosses? These funds and institutions are legally required to report their major movements each quarter, and many publicize positions for other purposes, including to generate retail interest. Granted, the timing might be off on some of the trades, since they only need to report their activity within 45 days of the end of each quarter, but if you’re a long term investor, it shouldn’t make that much of a difference. But you’ll still get their trade ideas, which you can analyze on your own and decide whether to use them or not.

Cons

Account Size

Someone with a large account size might be willing to take trades that aren’t the finest if the trades only risks a tiny fraction of their account. It’s like a high roller throwing down a few chips on a number at the roulette table. Losing simply doesn’t matter. But for someone with just a few chips, putting one of them on a number and losing will most likely have a significant impact on the better. Doing that a few times will put him out of business.

When you follow a large trader you need to be aware that they might be willing to lose the entire bet because it’s such a small percentage of their account. While 95% of their trades might be based on A+ setups, they might be willing to play 5% of their trades as pure lottos, which they’re willing to let go to zero. If this happens to be one of the trades you decide to follow, there’s a good chance you’ll get destroyed.

If the master trader knows that traders are following him, he will hopefully let his followers know that his trade is a lottery ticket so that they can decide for themselves whether to take the risk or not. But if you’re following hedge funds, institutions or traders that are not catering to followers, there’s no way you can know the nature of their trades.

Position Size

Even if the trader your following announces that he’s taking an A+ setup trade, you still have no idea what his position size is, unless he reveals that, which most traders don’t. Position sizing is a key component of risk management. So let’s say the master trader says he’s buying TSLA shares for a day trade. Since you don’t know how many shares he’s buying, you can’t know how much room he’s willing to let it go against him before stopping out.

Let’s assume that he bought 1000 shares at $200, and you bought 100. The stock pulls back to $195, and your down a quick $500, which for you causes the same result as sitting in a sauna wearing a winter coat. You cannot afford to lose $500 dollars today! But for the master trader, a $500 loss is very much within his risk profile. You can’t bear the pain and bail. He holds for another couple of points until the price hits a support level and then reverses and heads to $205 (for a quick $5000 profit).

Had you known that the master trader was position sizing to risk .5% of his account, and that his account was $1 million, then you would understand that you should only risk .5% of your 50k portfolio, or $250, which would mean you’d need to size your position to 50 shares or, if that wasn’t interesting enough for you, just skip the trade altogether and wait for a trade in a cheaper ticker.

In almost all cases, you won’t know the position sizing of the trader that your following, so if your planning to follow his exit (for gain or loss), you’ll need to make your own calculations about where your stop should be and how to size accordingly to avoid getting shaken out of the position too soon or taking a much too large loss if you get stopped out along with the trader your following.

I personally have tried to follow a particular options trader into trades with very expensive contracts (like SPX or pre-split AMZN and TSLA), which he ended up holding through major pullbacks, during which the contracts lost over half of their value. I was unable to hold through those pullbacks because the pain was too great. But since he was able to hold, he almost always ended up getting out for a nice profit. While the unrealized loss during the pullback was manageable for him based on his account and position size, it wasn’t for me. I should have realized that and either sized my position size accordingly or, if that would have been less than a contract, not taken the trade at all.

Position size and overall account size play a massive role in planning a trade and managing its risk. If you’re going to follow someone else’s trade, you MUST take those factors into account.

Trade Intention

If you’re following institutions or large smart money players based on dark pool or option flow activity (which I’ll discuss in chapter XX), you have to take into account that you don’t know the intention behind their trades. For example, you might see a million dollars in call flow coming into a ticker and assume that the smart money is bullish on the stock. But it’s very possible that the institution buying the calls has a $100 million short position in the stock, and is simply looking to hedge the position. In other words, what looks bullish to you is in reality super bearish.

There’s no way to know what the intention behind a large trade is, so you can’t follow it blindly. You need to try to discern the intention of the whale trade by looking at the charts and to see where the support and resistance levels are, which could then give you a clue as to what direction the traders are actually betting on. Of course, there’s no way to know for sure what their intention is, but as least you can try to get the probabilities on your side to then decide whether to follow the trade or not.

Frontrunning

Finally, there are plenty of unscrupulous traders looking to make money off of their followers by frontrunning them into positions. This often happens in “Twitter pumps”. Here’s how it plays out. The trader will tweet out to his many followers to buy XYZ 25 calls for $1. He has already bought 1,000 of those calls.  Now his followers start piling into the calls, elevating the implied volatility and pushing up the price. The calls quickly move to 1.20, 1.40, 1.60, 1.80 — the excitement builds as more excited followers buy the calls at higher prices. Suddenly, a huge block of calls hits the market and start driving down prices quicker than a falling piano. The price quickly comes back to $1, leaving a bunch of eager traders sideswiped. What happened? The trader guru created the hype so that he could sell the calls to his follower at the top. While he made out with a 6 to 8 thousand dollar windfall (not too bad for an hours work), his followers were left holding the bag. Things that move up super quickly for no apparent reason, tend to fall back just as quickly.

If you’re going to follow a trader, make sure he or she is reputable and ethical. You don’t want to be the one holding the bag at the end of a frontrunning Twitter pump.

Bottom Line

• Vet traders thoroughly before following. If a trader claims never to lose, they’re likely a fraud. Even the best traders take losses—it’s part of the game.
• Never copy trades without considering your own risk tolerance and account size. What works for one trader might be totally impractical for another.
• Aim to learn from great traders, not just follow them.

There are some great, and honest, traders out there who sincerely want to help new traders succeed. Some of them charge hefty fees for their knowledge, and some do it for free. It’s a tremendous benefit for any new or less experienced traders to be able to learn for someone whose made the mistakes, learned from them and gone on to become a successful trader. But even if you do find one of these gems, don’t blindly follow them. They don’t want you to, and they’ll tell you that straight out. Learn from them, see how they trade, and then make you’re own trading plans based on your own account size, risk tolerance and trading objectives.