Some Thoughts on Paper Trading

Not everyone believes in paper trading.  Here are the thoughts (link no longer active) of one nay-sayer.  The primary reason is that it's not real money and that no emotions are involved in the decision-making process.  In addition, there's a temptation to turn the paper trading into a game.

I cannot disagree more.  First, the successful trader must learn to control emotions, and if you can make emotionless decisions when it's practice money you may be on your way to doing the same with real money.  

If you want to be a winning trader, you should begin by taking paper
trading seriously.  You must concentrate on making good decisions and  it's a good to experiment.  In
fact, that's part of the learning process.  Try something, decide if that
trade fits within your comfort zone and try to learn from this new (for you)
type of trade.  It's an intelligent idea for trying out a new strategy.

Important: Do not decide that any new trading idea is 'good' or
'bad' based on one result.  There is always some luck involved
when investing, trading or any other activity for which the outcome is uncertain.  Consider the trade chosen and the result.  Decide if the
result was reasonable or an unlikely outcome.  Analyze whether you were
comfortable owning the position day after day.  Rinse and repeat.

That's the learning process.  It takes time. 
Please remember that there are millions of kids who want to be professional
athletes.  Some put in lots of practice time and are able to make their
college teams.  Some make it to the professional level.  But very few are Michael Jordan. He did not get there by taking shortcuts.

Practice is one key ingredient to success.  Talent is
another.  Not everyone can be a winning trader.  If you practice and
learn and still cannot make money, there is no reason to believe you will do
any better when trading with real cash.

To me, the difficult part is the patience required.  A
day trader makes many trades over a short period of time.  He/she gains
experience quickly.  But for option traders who hold positions, such as
covered calls, butterflys, or iron condors – a single trade can take a month or
two.  That requires enormous patience when trading with play money.

Anyone using a paper account wants to get practice and experiment with
various ideas.  But it does take
time.  You can trade real money and a practice account at the same time,
but one ingredient for success is the ability to recognize when you don't know
enough to make good trade decisions.  It's seldom as easy as: open the trade, close the trade and deposit your winnings
in the bank.  Many times questions arise and decisions must be made along
the way. 

Do I suddenly have too much risk?  How can I fix that?

Did I earn enough profit?  Should I exit now and take
it?

The position is not working.  Exit or wait?

The market is suddenly more volatile.  What should I
do?

Am I trading proper position size?  How can I find out?

The answers are not obvious.  It takes experience
to get a better understanding of how decisions are made.  Sure you can
trade with real money, but only if you place a very small portion of your
assets at risk.  If you have a $100,000 account, you can afford to trade
one-lots instead of paper trading (although I recommend paper trading). 
But if you have $10,000, you don't want to lose $500 or $1,000 per trade just
to get your feet wet.  It's not worth the risk.

If you can handle multiple positions without getting
confused, that is one way to learn and gain experience more quickly.  For multiple positions, I
suggest different expiration months or different stocks (or ETFs or indexes) to
keep each position isolated from the others

RookiesCover

702


"I am currently reading your book " The Rookies
Guide To Options" and must say that it is excellent.  I have no experience
trading options and was always a little "scared" of the subject but your book
puts everything into perspective i
n a very reader friendly manner." TK

 

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8 Responses to Some Thoughts on Paper Trading

  1. Rick F. 05/28/2010 at 7:42 AM #

    I agree 100% Mark. Papertrading is very helpful in learning the dynamics of the market .. especially if one daytrades, particularly futures (like me.)
    The lack of an emotional aspect is perhaps the biggest problem I have with papertrading — especially when I would be profitable on paper and yet lose for real. Ultimately I realised it was the emotional aspect of being in the market that was tripping me up and keeping me in losing trades and/or cutting winners early. It also *really* taught me how not to overtrade and be patient, waiting for an appropriate trade setup to happen. Discipline, you know.
    When I went back to the “sandbox” to figure things out, what I did to try and simulate the emotional aspect of trading was to use a much larger position size — ie, if I was trading live with 1 futures contract, I would use 4 or 8 or 16 on paper. That way, when the losses (or wins) start to add up, you really take notice. Plus, I found it helped me manage trades much better and learn how to endure ‘market noise’ without panicking and closing out my position out of fear.
    This sounds odd, and crazy — I mean, why would someone “break the rules” and trade like that, even in a simulator? Simple. If I was minus $25 or $100 per tick or trade on paper, my response was most likely “Meh. Minor loss, better luck next time.” Minus $250 or $1000 per trade on paper on the same trade? “Whoa, what am I doing wrong and why?”
    It may sound weird, but as a futures trader, this helped me immensely in managing my emotions and being able to manage a trade and profit by not panicking — even when the trade instantly goes against me.
    Not sure this applies to options traders but I figured it worthy to bring up here anyway.

  2. Mark Wolfinger 05/28/2010 at 7:55 AM #

    Rick,
    One reason it’s so easy to earn money with paper trading is a topic I should not be ignoring:
    Some brokers make it very easy to get fills with paper trading accounts. These are fills you could never get in the real world. I find that to be extremely dishonorable, but it is one way brokers make money. They get people to make real trades and pay real commissions before they are truly ready to trade.
    If you recognized the importance of emotions, that’s a huge piece of information. Many never realize that fact. Overcoming it is more difficult for some than others, but understanding the problem is more than half the battle.
    I like the idea of trading more size in the simulator, but with that must come the recognition that it really is too much size when using real money. However, I don’t believe the reason should be to make the size of a win or loss large enough to get your attention.
    You should be thinking in terms of percentage gains and losses (based on money at risk) – not not in terms of total dollars.
    One more point: Just because you are losing on a given trade does not mean you are doing anything wrong. If you are day trading, it just means your trading premise is not being realized and that what you anticipated did not come true. That’s not a mistake because you know you are only going to win on some trades, not all. What is a mistake is stubbornly refusing to admit that you did not read the market correctly this time.
    Almost all ‘trading skills’ apply to options traders to some extent. But when the positions are held for weeks, instead of minutes, there are different priorities. Thanks for the contribution.
    Regards

  3. Rick F. 05/28/2010 at 8:14 AM #

    Presicent comments, as usual, Mark.
    Yes, the caveat applies on position sizing and knowing what you’re doing is for paper trading purposes only. Once I went back into the live side, I returned to my 1 contract lots and then scaled up as time and performance warranted. Had I done otherwise, I’d not be around today. 🙂
    You said: “Just because you are losing on a given trade does not mean you are doing anything wrong.”
    AMEN!
    In the futs markets, I find folks will panic very quickly and ultimately be proven right had they just held through the market noise of the given time of the tape. As a result of what I did on paper, no longer am I itching to close a position if I enter and 5 seconds later it goes against me slightly — something that can be very brutal if you enter a trade and the market suddenly begins to chop around and you exit, enter, exit, and end up making your broker happy while you never profit … when had you stuck to your trade and “weathered the noise” you’d have been profitable. Here agian, paper trading helped me learn to control emotions and not react to the short-term noise but rather wait for a longer-term movement to occur; at which point it’s decision time.
    Like turbulence in the air, you may get anxious or break into a small sweat, but my view is that the best option – no pun intended – is to ride it out (unless a wing falls off.)
    Bottom line: Stocks, futs, options, fx, the psychology is the same. Emotions are a big part of trading success (or failure) regardless of whatever timeframe and product(s) we trade.

  4. Mark Wolfinger 05/28/2010 at 8:30 AM #

    Agree with all. Just a warning that ‘riding it out’ – for some people – means never folding the hand.
    That’s a no-no

  5. Brent 05/28/2010 at 2:22 PM #

    I couldn’t agree more with the value of paper trading. When I first started trading options I looked at paper trading as something to “get out of the way” so I could start making big money. I paper traded for a few weeks, made a big profit on one trade, and thought I was ready to go in with real money. I then lost a lot of real money on trades because I just wasn’t ready yet.
    Now I do a lot more paper trading to try out new strategies and see what pans out and what doesn’t. My advice to someone starting out trading is that when you think you’re ready to start putting down real money on trades you are only half-way done with paper trading.

  6. Mark Wolfinger 05/28/2010 at 4:29 PM #

    Brent,
    Trying out strategies is one special way to paper trade. I’m sure most experienced traders would never bother to do that. But experimentation and note taking provides data unavailable anywhere else – at no cost.
    Thanks for sharing

  7. Gavin 09/27/2011 at 3:45 PM #

    Hi Mark,

    What a fantastic article and some great advice you are providing here. When traders are writing down their paper trades, they should take note of the current price of the stock, their stop loss and profit target levels and also their reason for the trade. They should then go back and review this trading journal each month to see what worked and what didn’t. This is the best way to improve your trading in my opinion.

    I also recommend paper trading for experienced options traders when they are trying a new strategy that they have not traded before.

    Another thing I highly recommend for option traders is a detailed trading plan. Traders should have an overall trading plan, and a trading plan for EACH strategy that they are trading. Something that says “If X happens, I’ll do this. If Y happens, I’ll do this” etc. These are all things you can practice when paper trading

    Thanks again for the very informative article.

    • Mark D Wolfinger 09/27/2011 at 7:28 PM #

      Nice try.
      Your obvious spam was deleted.