In recent years, there has been a growing interest in the role played by social media in the finance industry, mainly due to the vast amount of data collected by social platforms, and the ease with which individuals can communicate and obtain information in real-time.
Researchers and practitioners have studied the relationship between the information amassed by social networks and the dynamics of financial markets, which are essentially driven by investor sentiment. For instance, Bollen et al. (2011) find that the public mood expressed through live Twitter feeds can be used to predict the daily movements in the Dow Jones Industrial Average (DJIA) with an accuracy of 87.6%. Moreover, investment firms have quickly adopted social media tools and capitalized on the opportunities brought forth by social media, such as Derwent Capital Markets, which pioneered a $40 million hedge fund that traded on market sentiment using real-time Twitter news feeds. The innovative integration of social media into finance applications has inaugurated a new branch of research called social finance, which investigates the effects of social interactions on financial outcomes (Knorr Cetina and Preda, 2004; Preda, 2007; Hirshleifer, 2015). One particular phenomenon that has attracted hundreds of thousands of traders and investors in recent years is called social trading.
Social Trading Platforms
Social trading merges the traditional online trading model with the tools provided by social media platforms. The result is a pioneering and highly transparent marketplace called a social trading platform (STP), where participants can communicate with each other, collaborate on tasks, and even explicitly copy each other’s trades in real-time using a mirror trading algorithm. The latter allows individuals to set up their account to mimic all future trades of one or multiple traders, thus any trade that is executed by a copied trader is also executed in the copier’s brokerage account at the same time and price. For mirror trading to work, STPs typically require individuals to reveal their current portfolio holdings, historical trading activities, and online social interactions to a network of participants, which is a level of transparency that is lacking in traditional financial institutions including banks, mutual funds, hedge funds, and on exchanges where participants trade against each other and try to keep their strategies and holdings secret.
The Scopic Regime
The trading environment governing STPs is called a “scopic” regime, which signifies a situation with high information transparency where participants constantly and reciprocally scrutinize each other’s actions (Knorr Cetina, 2003). Unlike an institutional fund management setting, the unprecedented high level of transparency offered by STPs allows participants to easily examine the past and current performance of others in real time, which is calculated using raw data. This highlights a key attribute of STPs, in that they offer a formal ranking of traders and a range of real time performance and risk metrics such as holding period return, profit and loss, volatility, maximum drawdown, number of different assets traded, and trading frequency to name a few, as well as social indicators including the number of copiers and ranking relative to others.
Why do Traders Share?
At first encounter, it may seem irrational for participants with a profitable trading strategy to disclose all their historical trades and portfolio holdings to complete strangers. However, STPs have incentivized this behavior by encouraging individuals to build a reputable track record and providing them with remuneration packages that are similar to those offered by investment funds. Some STPs adopt a performance-based compensation scheme where traders are compensated depending on the return they generate for their copiers. Other platforms employ a neo-asset-based compensation scheme that links the trader’s remuneration to the number of copiers, instead of the amount of assets under management. A trader’s choice of which STP to use may be largely dependent on the compensation scheme offered, which suggests that each platform attracts a different type of audience. However, it is important to note that STPs can and do change the compensation schemes they offer in order to potentially attract more traders, and to retain incumbent ones.
Trade Leaders and Investors (a.k.a. Copiers)
This principal-agent relationship, which arises due to mirror trading, allows us to categorize participants into two main groups, which we call trade leaders and investors (or copiers). Trade leaders are typically experienced traders who conduct their own research, execute only unique personal trades (i.e. refrain from explicitly copying others through mirror trading), and invest the capital allocated to them by investors in return for monetary compensation. An investor can allocate and diversify his entire capital across several trade leaders by simply opting to copy these individuals, thus having all their trades replicated in his account. This means that any trade executed by the trade leaders that the investor is copying is simultaneously executed in the investor’s account at a price identical to that received by the trader, and without the need for manual confirmation. The investor does not need to intervene except for terminating the copying relationship. Since all trades are executed automatically, the investor can simply allocate his capital to be managed by other more experienced traders, and can diversify his investments across multiple trade leaders with different trading styles with the aim of decreasing overall portfolio volatility.
Some individuals may choose to allocate only part of their capital to be managed by trade leaders, while reserving the rest for their own personal trading. Hence, it is important to take this into consideration when analyzing the performance and skill of these individuals.
While an investor can set up his account to mirror that of a trade leader, the investor still enjoys the authority to modify the copied trades as he pleases. For example, an investor might copy a market order from a trader to buy a certain currency pair, but wishes to add a stop-loss level. Even though the investor changed the terms of the trade, such an action is still considered a copied trade. Nevertheless, the relationship between trade leaders and copiers is largely informal, as there are no official sanctions should trade leaders go rogue, deviate from their advertised strategy, or lose their investors’ money. Similarly, investors can terminate the copying relationship at any time without facing any repercussions.
The Socio-Financial Asset
STPs have given a new literal meaning to the phrase “investing in people”. Mirror trading essentially gives rise to a new “socio- financial” asset, whereby the trader that is being copied may be perceived as a tradable, long-only asset whose risk and return characteristics are driven by two components; the performance of the financial assets traded and the behavior of the trader. Investing in socio-financial assets can be done by simply opting to copy the trading activity of others.
A Move Back to the Trading Floor
The concept of social trading is not entirely novel as social interactions, such as com- munication and physical contact, have been an integral part of open outcry financial exchanges. In trading pits, traders try to decipher the motives and emotions of other market participants and adjust their positions accordingly. However, these exchanges have experienced radical technological and operational changes since the introduction of electronic communications networks in the late 1960s, an innovation that relocated traders from trading floors and positioned them in front of screens. While electronic trading does have its benefits, such as increased efficiency, speed in trade execution, fewer mistakes, and lower monitoring costs, several academics have highlighted the benefits of floor trading that arise from trader interactions on the floor, which was lacking in early electronic systems. For instance, Ates and Wang (2005) find that floor traders 1) know who they are bidding against, 2) can select their counter-party as opposed to electronic trading, and 3) can quickly change their price quotes by a simple hand signal thus canceling any previous offer or bid, which is a very valuable option in highly volatile markets.
STPs come as a modern and innovative transition “back to the trading floor” by combining the strategic information generated from trader interactions as documented in floor trading systems, with the increased efficiency and speed of electronic trading. This amalgamation has resulted in several unique features, which render STPs an entirely new trading environment. STPs encourage, and have incentivized information sharing, hence participants on these platforms have access to high quality order flow as well as social information, which is essential for making informed trading decisions. This is one of the main advantages for small retail traders who seek high-quality information related to market outlook but are often faced with the challenges of a clandestine and very costly traditional investment system. Hence, STPs are a materialization of what an ideal market would look like in the eye of an investor, and it is this transparent environment that is attracting a larger crowd of retail traders.
Ates, A. and Wang, G. H. K. (2005). Information transmission in electronic versus open-outcry trading systems: An analysis of u.s. equity index futures markets. Journal of Futures Markets, 25(7):679–715.
Bollen, J., Mao, H. and Zeng, X., 2011. Twitter mood predicts the stock market. Journal of Computational Science, 2(1), pp.1-8.
Cetina, K.K., 2003. From pipes to scopes: The flow architecture of financial markets. Distinktion: Scandinavian Journal of Social Theory, 4(2), pp.7-23.
Hirshleifer, D. A. (2015). Behavioral finance. Annual Review of Financial Eco- nomics, 7:133–159.
Knorr Cetina, K. and Preda, A., 2004. The sociology of financial markets. Oxford University Press.
Preda, A., 2007. The sociological approach to financial markets. Journal of economic surveys, 21(3), pp.506-533.