The Trading Signals Industry: A Closer Look

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If your strategy delivers consistent risk-adjusted returns, why sell trading signals at all? Do the risks really justify the rewards? Read on to find out.

If you’ve ever run a Google Search for “trading signals”, you’ll have seen a plethora of paid ads, videos, blog posts and other organic listings, all featuring trading signal providers across multiple asset classes, primarily Forex and stocks.

Some will have been individuals selling Email/SMS or Telegram based services.

Others, full-blown works of software engineering art: web-based platforms built from the ground-up complete with:

  • customer on-boarding
  • signal copy/provision
  • payments processing
  • marketing automation, and
  • back-office capabilities.

Given the scale of things as described above, one has to wonder..

What actually drives the trading signal industry?

For one, the exciting prospect of generating gains from capital markets is one many of us have experienced at one point or another.

  1. If you’re a retail trader, odds are that you’re under-capitalized and possibly in need of additional income to make it worthwhile — especially if you have a great trading strategy that delivers consistent risk-adjusted returns.
  2. Selling your entries/exits as signals — in theory — may help work towards that goal — but not so much in practice.. as we’ll discuss shortly.
  3. If you’re someone who doesn’t have the know-how, skills or expertise to deploy capital directly to the markets, you may be open to someone more qualified managing your capital for you.
  4. Hedge funds won’t give you the time of day if you show up with anything less than $500,000 to $1 million in most cases.. which is the case with a majority of retail investors.

All of the above and more, yields conditions ripe for the trading signals industry’s continued existence, seemingly:

  • reducing capital barriers to entry for investors, and
  • regulatory barriers to entry for providers

..or do they really? (more on this shortly)

Say your trading strategy delivers consistent risk-adjusted returns.. why sell trading signals then?

Well-intentioned traders may consider doing so as a means to generate additional income and/or trading capital, at the cost of parting with their intellectual property.

The risk of their strategy eventually being reverse engineered by the very clients they’re selling it to, while very real, isn’t initially a stumbling block for some traders.

Neither is falling foul of asset management regulation.. the availability of PAMM/MAM platforms domiciled in questionable jurisdictions facilitating things further.

Now let’s dig a little deeper into the incentives that may drive a trader to sell trading signals

Let’s say a trader invests in the Forex market with a strategy that yields 20% on average per annum with a maximum drawdown of 10%.

The trader’s progression with a 20% annual return, and starting capital of USD 10,000 is therefore:

Year 0: USD 10,000
Year 1: USD 12,000
Year 2: USD 14,400
Year 3: USD 17,280

Indeed, the trader makes a very impressive 20 percent year on year.

Yet in dollar terms, he makes only:

  • USD 2,000 in year 1
  • USD 2,400 in year 2 and,
  • USD 2,880 in year 3.

In reality, the problem isn’t that trading returns are too low.. 20% annually is amazing.

The problem lies in the limited starting capital: USD 10,000 in this case.

If you trade peanuts, you will only ever make peanuts.

trade peanuts, make (or lose!) peanuts

In theory, selling trading signals could improve the trader’s pay-out, the subscription fees contributing to overall returns and/or towards increasing trading capital.

But at what cost?

Is the trader really making sufficiently more income to justify taking on tremendous risk in the form of regulatory non-compliance and performance fees left on the table?

What alternatives does the trader have?

Could he borrow to lever his payout from 20%?

Let’s say he gets 5:1 leverage.

Now with his own USD 10k in proprietary capital, he’d be investing USD 50k.

If he makes 20% return he’ll earn USD 10k or 100% of his initial capital.

Sounds great, right? ..what about the drawdown?

Well, if he gets off to a bad start and has a drawdown of 10%, he’ll be substantially underwater having lost USD 5k or 50% of his own capital!

Now let’s say instead of 5:1, the trader goes for 20:1 leverage.

Now with USD 10k, he’d be investing USD 200k.

If he makes 20% return he’ll earn USD 40k or 400% of his initial capital.

Fantastic right? oh wait, the drawdown again..

Should a drawdown of 10% surface at the wrong time, he’ll lose around USD 20k.

But he only had USD 10k to start with.. behold, yet another blown account.

If the trader was also selling signals at such time, the service would effectively grind to a halt, leaving any trading signal subscribers with irrecoverable losses and no future service from the same provider.

In summary, by increasing leverage as an alternative to selling signals for additional income, the pay-out function becomes:

  • Either huge upside or..
  • TOTAL LOSS of capital and more importantly, credibility.

Furthermore, the trader is not a risk-neutral robot, so loss aversion may well negatively impact his track-record faster than excess leverage ever could.

Trader & Investor Incentives

To answer these questions, let’s bring an investor into the picture.

This individual has USD 10 MM sitting in his bank account, earning a consistent 0% per year… sarcasm fully intended.

Somehow, the trader and investor meet, and hit upon their mutual win-win opportunity:

  • Trader owns intellectual property that can generate 20% a year
  • Investor has USD 10 MM (unlevered) sitting idle
  • Trader’s strategy could lever investor’s 10 MM, generating USD 2 MM surplus profits every year.

For this to happen, the trader & investor need:

  • Each other, and..
  • An acceptable pay-out function (not trading signals)

The “mutually acceptable” pay-out function

However before we delve into what that is, let’s examine how the trader’s life has changed for the better — without selling his IP as trading signals..

..because it’s important to reflect on WHY this changes the trader’s game.

An investor is a far more powerful force than the house

Capital Asymmetry

The investor changed the trader’s game because with a 20% return, the trader’s payout becomes:

  • USD 2k profit on the trader’s own capital
  • PLUS, and only “plus” whatever the investor agreed to pay him

Because it’s only positive (=asymmetric), “plus” makes ALL the difference.

  • If the coin comes up heads, the trader extends his payout through performance fees from the investor’s profits.
  • And if it comes up tails, he only loses his own money (the investor loses money but the trader is not impacted by the investor’s loss)
  • 20:1 leverage with drawdown of 10%, the trader would have blown up his account.
  • Trader levering the investor’s capital, with a drawdown of 10% he’d only lost $1k of his own money.

Manager & investor alignment

This brings us to the contract between the trader and investor.

How should the trader structure the capital asymmetry he offers this investor (and all future investors)?

Should he:

  • sell the investor trading signals?
  • package his strategy into a automated trading robot, a MetaTrader EA or Expert Advisor?
  • operate a MAMM account?
  • operate A PAMM account?
  • start his own Hedge Fund?

Certainly there are some considerations he might want to take into account.

After all, he:

  • Might fall foul of asset management regulation if he picks the wrong approach from the list above!
  • Could have to take out a lot of risk to legally manage investor money.
  • Might undervalue himself in a rush to pick the short-cut and churn dumb investors by selling trading signals.

..or he could simply list a DARWIN at Darwinex!

Unlike trading signal services, a DARWIN (Dynamic Asset & Risk-Weight Investment) brings a meritocratic league of alternative data accessible to all stakeholders under one roof, traders and investors alike:

  • Trader lists trading strategy as a directly investable asset on the DARWIN Exchange (click here to see how this looks)
  • Investors take traders’ alpha directly to market, swapping cost of acquisition and process for fair compensation to traders instead.
  • Compensation is commensurate to investor capital deployed to market — not flat fees as would be the case with selling trading signals.
  • Investors replicate a trader’s signal in real-time, traders charge a performance fee on investor profits for providing the service (click here to see traders ranked by performance fees earned).
  • Investors are informed of a trading strategy’s capacity in advance, traders have complete control over capacity management in case of over-capitalization risk.

Retail and institutional -> size does not (and should not) matter.

All investors have equal access to traders’ strategies (DARWINS) listed on the DARWIN Exchange, competing fairly for a share of the available capacity.

  • All investors have equal, non-preferential access to the DARWIN asset universe.
  • There is absolutely no way to disseminate information outside the ecosystem without fairly compensating traders.

Containment within the Darwinex ecosystem and regulatory cover for traders to legally charge performance fees ensures they get adequately compensated for signal provision.

If the solutions above have piqued your interest, watch the following video from the Quant Conference in London on November 01, 2019, where Darwinex CEO Juan Colón shed light on why and how Darwinex is democratizing the financial landscape:

About Darwinex (www.darwinex.com)

Darwinex is a Broker, Asset Manager and Technology Provider, duly authorized and regulated by the Financial Conduct Authority (FCA) in the United Kingdom.

Founded in 2012, we employ more than 40 across our London headquarters and our development office in Spain.

In our quest to democratize the financial landscape, we’ve:

  1. Engineered the technology necessary to wrap investment strategies as an asset class.
  2. The DARWIN asset/wrapper lets investors invest in / trade manager talent, alpha and community sentiment in real-time, while fairly compensating for trader IP.
  3. Eliminated the startup costs and regulatory overhead associated with starting a hedge fund, enabling under-capitalized talent to compete at institutional scale under our regulatory umbrella — the foundation of our Hedge Fund as a Service business model.
  4. Successfully assetized both positive and negative alpha, enabling anyone with access to our community data to engineer investment strategies uncorrelated to any other asset class in existence.
  5. We’ve hence created an ecosystem for traders and investors to pool collective talent, information and capital for private and social benefit, one that:
  • Structurally solves the “manage peanuts, make peanuts” problem faced by under-capitalized talent
  • Facilitates equal access to all stakeholders
  • Facilitates merit-driven access to investor leverage with no downside risk.
  • Investors compete fairly for their share of alpha capacity.
  • Demonstrably improves trader satisfaction better than our competition.
  • Enables investors to swap alt data acquisition and processing cost for fair compensation to traders.

Full-Stack Data & Decision Scientist | Quant | Educator | Problem Solver | P.Lang’s: C | C++ | Python | Julia | (LinkedIn: https://www.linkedin.com/in/ali-saif)