eToro Tips: Money and Risk Management

eToro Money Management TipsMoney Management is a key component to any successful trading strategy and also when you copy other traders with eToro it’s important you understand and manage the risk of your account.

In terms of the amount can invest in each trader (“Professional Investor”) there are 2 restrictions which apply on eToro:

  • you can only invest up to 40% of your realized equity in a single trader
  • you need to invest a minimum of $100 on a single trader

Within the allocation you make to each trader, the actual leverage and risk the trader applies to their own account is replicated proportionally to your allocation in them. I.e. if they risk 5% on a trade in their account, 5% of your allocation is risked, and if you were allocating 10% of your funds to that trader this means 0.5% of your total balance is risked. The risk in your account is therefore totally linked to the traders you copy and the only way you can manage the overall risk level of your account is by changing the amounts you allocate to each trader (and the stop loss you apply). From experience, we’ve noticed the risk levels range from 1% per trade to 100% per trade (yes that means all risked on 1 trade!). Hence it’s important you understand the risk level of each trader you copy or plan to copy on eToro.

For each of the traders eToro displays a risk score graph as well as their maximum daily, weekly and yearly drawdown in their profile. The risk score is a proprietary eToro value which takes into account choice of instruments, choice of leverage, the percentage invested on a single instrument and more. The full algorithm isn’t shared but here’s more info on the eToro risk score. The value ranges from 1 (low risk) to 10 (high risk) and is updated periodically (i.e. not real-time!). However instead of just trusting and using this proprietary value (which cannot be verified), the historical drawdown levels are a great indicator to evaluate how risky a trader has been in the past.

The historic drawdown levels are also the best indicator to use if you apply a stop level to the eToro trader you copy. I.e. the stop level will ensure you automatically stop copying a trader and all existing open trades from them are closed once they lose a specific $ amount or % of the amount you allocated to them. Setting the stop level too low will however mean that you might get stopped out too quickly. E.g. if historic maximum weekly and yearly drawdown was 20%, setting it at this or a lower level will highly likely mean you get stopped out. Assume that’s it’s very likely that in the future traders will reach or surpass their previous historic drawdown levels, especially if they have longer terms strategies with high winning ratios which leave trades open over a long time.

The best (and sometimes only) way to get an indication of how much a “Professional Investor” risks per single trade is to copy them using virtual money in a demo account (click here to open free eToro demo). Looking at the “amount” and “units” columns in the “open trades” and “history” tabs in eToro Webtrader gives you an indication of how much the trader risks on each trade. Let’s look at the example which shows 3 trades from 3 different traders in the history tab. All 3 traders were allocated $1,000.

eToro History Trade Risk Sceen

Example of eToro Trade History

From the units we can deduce that viking1961 was risking $1.5951 per 1 pip movement on this trade (pip value calculator), while risking $638.04 of our allocation to them on this trade (the “amount value” relates to the distance of the stop level). erohal2009 was risking $0.02645 per pip and $10.58 of allocation on their trade and cemara1 $0.8883 per pip and $88.83 respectively.

From this data we can therefore deduce that of these 3 traders, erohal2009 was risking by far the least on their trade. We can also see that while cemara1 was risking about half as much per pip as viking1961 ($0.8883 vs $1.5951), they were actually proportionally using much less of their allocation on that trade ($88.33 vs $638.04). That’s also the reason why cemara1′s gain % on the trade is almost the same as viking1961, even though they only made 6 pip on that trade vs 27. I.e. they made those pips by using less capital.

So to summarise, the pip risk tells you how much you win or lose on the trade when the market moves 1 pip and is the key indicator of how much a trader is risking on market movements.

The levels used for the trade will more depend on the strategy of the “Professional Investor”. DayTrading traders are more likely to use stops 100 pips away while longer term strategists may use 500 pips. Obviously if the market moves 120 pips against a position, but then comes back to break-even, the first trader would be stopped out (and lose 100 pips) while the second trader would still be in the trade. However, the second trader is risking and therefore locking in much more of your allocation on the trade (which cannot be invested elsewhere).

Both strategies have their merits but it’s worth noting that some traders on eToro may widen the stop levels of a trade over time. However if they use fresh capital to offset against the increased level, it’s likely you will be stopped out stopped out for this trader unless you allocate fresh funds to them.

The examples above should now allow you to create an understanding of the risk profile of an individual trader on eToro. When you’ve categorised the traders you want to copy, you can then apply this to the overall risk profile you want to apply to your eToro account. E.g. you can decide to invest 75% in low risk traders, 20% in medium risk and 5% in high risk traders.

Please note that it’s not within our remit to make suggestions of what overall risk profile you should take (please contact a financial advisor for this). The information we provide here is for information purposes only. Investing on eToro (and any other social trading network) is subject to investment risk, including possible loss of part or all of your initial investment.

Deciding when to invest is another part of your money management strategy and a key factor of your performance. eToro “Professional Investors” will have winning and losing streaks (just like markets can go up or down). There’s no way anyone can predict their future performance in advance and hence you cannot foresee the perfect timing to invest in them. Here are some examples:

1) If you invested $1,000 each in the 10 most popular eToro traders (most copiers) on May 1st 2012, your net position (incl. open and closed trades) would be $7,240 after 1 month and $8,334 after 2 months (30th June 2012). If however you invested $10,000 in the 10 most popular traders on June 1st 2012, your net balance would be $11,360 after 1 month.

2) Looking over 1 year, investing $1,000 each in the top 10 eToro traders in May 2012 would have resulted in a balance of $8,726 after 1 year investment (30th April 2013) and $8,571 after 13 months. Investing in the top 10 on June 1st 2012 would have resulted in a balance of $9,237 by May 31st 2013.

3) At a trader level there are similar differences. If you allocated $1,000 to Malsolo on May 1st 2012 your net position would have been $750 after 1 month and $1019 after 2 months. If you invested $1000 in Malsolo 1 month later (June 1st 2012), you net position would have been $1292 one month later (end of June 2012).

4) Over 1 year, $1,000 invested in Malsolo on May 1st 2012 would have resulted in a net balance with him of $1,281 after 1 year and $1,302 after 13 months (end of May 2013). Investing the $1,000 in Malsolo on June 1st would however resulted in a net balance $1,637 after 1 year (31st May 2013)

You can view the details and screenprints of the 1 year eToro performance comparisons here.

As the examples show, it would have been better to start investing at the beginning of June than at the beginning of May, but unfortunately you could only know this in hindsight. Nevertheless, one way you can reduce the risk of investing at the start of a losing run is by phasing in your investment in a trader over a few weeks or months. I.e. spreading the risk. Even if you already have your funds in your eToro account (e.g. to benefit from their first deposit bonus) there’s no requirement to have them all allocated at once.

Copy open trades or not?

eToro introduced the option in December 2012 to copy a trader’s existing trades when you start copying them. By default this option is now selected as eToro believes that “this is the best way to experience the CopyTrader function”. We do however suggest you carefully consider whether you really want to copy the existing trades of a trader and hence lock in potentially a large amount of your capital straight away in those trades (some traders on eToro have already more than 80% locked in open trades!). Often those trades are still open because they’re in losing positions and hence do you really want to open trades in that direction as well?

A professional trader normally also has a reason to enter and to exit a trade (i.e. the trade story). However if you copy the trade halfway through, it’s a bit like walking into a movie or theater half way through the performance. Personally we never select this option ourselves. So if you’re not going to copy open trades on eToro, it’s also best to stay clear of traders who already have large amounts of their capital locked up (check portfolio tab in their profile) since they’re unlikely to enter many new trades until they close the old ones.

Locking in eToro trader profits?

There’s nothing more disheartening than copying a trader who makes 50% for you but then loses the profits and more with a few bad trades. If you’re worried about this, you can of course manually decrease your allocation. Or easier is to use the eToro stop loss feature to lock in the profits. E.g. if the trader already made $1,000 for you, make sure that’s the maximum they can lose (just making sure the new stop level isn’t too close).

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