Thoughts On Paper Trading

 

trading cartoon

I can’t think of too many careers where you would perhaps take a week-end course, maybe read a book or two, or watch a youtube video, and then come Monday morning, begin a retina transplant/proceed with opening remarks at a bench trial/draw up blueprints for an office tower/or replace the motor mounts on your family’s 2011 Dodge Caravan.

And yet in essence, that’s sadly what too many budding traders and investors do every week. Years ago, in a roundabout way, it’s what I did as well. Doh! I also tried to ‘play mechanic’ on my poor unsuspecting 1978 MGB at one point, but that’s a different story.

This is a career just like any other, and takes time and tuition from those that sign up.

There’s a school of thought that before putting real capital at risk, it’s best to paper trade first. I think paper trading has a place, and we’ll get to that in a moment, but for the purposes that most use it, there’s another approach to consider.

I’ve never been in combat, nor shot a live round at another human being, so I can’t presume to know what that feels like, or the emotions that go with it. Somehow I don’t think hunkering down for a week-end viewing marathon of Generation Kill cuts it. However, I have played a game or two of paint ball, and I assume that for as much as paint ball can get the heart racing, it feels substantially different when real, unforgivingly lethal, munitions are being propelled towards you with extreme prejudice.

Flight simulators have come a long way, and pilots are now able to practice flying, take-offs and landings at a plethora of real-life airports under every imaginable condition. A valuable and needed tool to be sure, but I’m guessing there’s a difference between sitting in a simulator showing nasty weather and an ill-lit runway, and coming into JFK in the middle of a February night with the sleet outside hitting your windscreen sideways, and 200 souls on board that don’t have the foggiest notion how to fly a Boeing 777, entrusting you to touch down safely. This, you’re thinking, is the real deal.

While actual lives may not be at stake when trading, the health of your finances – and possibly your loved ones – is most definitely on the line.

All of which is to say, that while paper trading may appear realistic, there’s no substitute for having real money on the line. You WILL feel and respond differently when the numbers are not simulated. So is paper trading a waste of time? Is there an alternative? Doesn’t it still kinda hurt to get hit by a paintball round? No, yes and most definitely.

First let’s look at where I think paper trading can be useful. If you’ve developed a system or a plan (and you should) and you know what needs to occur to get you into a trade (and you should) and know before entering a trade what your stop is/what would need to happen to prove your trade won’t be profitable (and you should), and you’re looking for a way to test what percentage of the time the strategy gives a negative result, then have it. It can be very useful in determining a failure rate.

What paper trading cannot do well is tell you how profitable a winning trade could be. And the reason is because in most cases, traders will react very differently under “live fire” than in a simulator. They may take profits too soon, let a winning trade turn into a loser, ignore or override their exit strategy because “this time it’s different”, the list is endless. Any trader that has watched the P&L in their trading account when a trade works violently for or against them knows what I’m talking about. And if it’s a new strategy, God help them.

So what’s the solution?

Trade real money.

Now, that does NOT mean that you take a 500 share position in $BAC on your next trade signal. What I would suggest instead, and what has worked well for me in the past, is to take a 5 share position. That’s right. 5 shares. Which in this case, would be about $75. Seems ridiculous, doesn’t it? But here’s the thing: the first objective this covers is that it gives you the ability to test your system, using real money, in the live market. If your system doesn’t work with 5 shares, it certainly won’t work with 500. But if it does work with 5 shares, then there’s a good chance it will work equally well with a full sized position (whatever that may be for your account). The second objective this addresses is it allows you to trade with just a hint of “live fire” coming at you, but not enough to either mortally wound your account, nor enough to distract you from the real objective..which is testing your strategy. Heck, buy 1 share if that’s all you need. If your system calls for you to sell half your position at a specific target, then buy 2 shares so you can do so.

Even though it’s a small amount of money, it will still give you a much better feel for not only how your system performs in real time, but how you as a trader react to what is happening before you.

Depending on your brokerage account and situation, there may be a concern that trading fees will make this an expensive exercise. I would argue that choosing to immediately go live with full sized trades and an untested system, has the potential to be far more costly, and potentially crippling to an account. Spend a little, to save a lot.

And this isn’t silly – no one is watching you, and quite honestly, no one cares. They have their own problems. Trading is about putting egos aside. If you had never worked out before, but read a Muscle and Fitness magazine on the week-end, would you march over to your fitness center on Monday, slap on a weight belt, stack both sides of the bar with plates and dead-lift the weight of a Smart car? Think you’d be back for more on Tuesday?

By the same token, what you would want to do is start small, and slowly work up with progress and confidence, getting your body used to working out, using real equipment, and a real plan.

personal-training

 

 

 

 

4 thoughts on “Thoughts On Paper Trading

  1. Pingback: Five Great Trading Articles For Weekend Reading

  2. All “get rich quick ” paint the allure of fast success, be it buying/flipping homes for no money down, multilevel marketing, trading, etc… =)

    The best use of paper trading using a good trading simulator is to develop a trading system that makes consistent profits over time. It won’t guarantee success when you switch to live trading, but if once can’t achieve consistent profitability on a sim, it’s a near guarantee that they will fail trading real money with the extra pressure that introduces.

    One can even add pressure to using a simulation to make it more realistic. Traders generally hat using sims and want to trade trade real money ASAP, so making a rule that one first has to be consistently profitable over X trades and Y weeks on a sim with a limited drawdown raises the stakes.

    The key is making the stakes high enough to add the fear of loss into the equation.

    • Thanks for commenting. Unfortunately – and this is only my own experience and some anecdotal evidence from other traders – even being routinely & consistently successful as a paper trader won’t necessarily translate to anywhere near the same success rate once real cash (whatever the amount) is on the line.

      Other traders may have differing experiences; I can only speak from my own. Trading for real money, even if only a very small amount, seems to yield a more accurate representation of a system.

      • Hmm, I find your results a bit perplexing. Assuming you have a system that generates an entry point, profit target, and stop loss, the bulk of the emotional factor should be eliminated which makes sim trading closer to the real thing. What do you think the difference is that affects your trading outcomes?

        My trades are semi-automatic in that when the trade is initiated, it already comes with a defined limit target, and attached stop loss order. That’s the same set up as my sim trade account, so the differences I perceive are minimal other that one is real money and the other isn’t.

        Now with largely discretionary trading, I can see emotions and fear of loss playing a big factor in using the sim vs real trade account.

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