The Wisdom of Paper Trading

Article By Rick Thachuk
World Link Futures

You’ve been to the library and various bookstores. Maybe you’ve subscribed to a trading course or two and you’ve been watching the markets on your own for a while. You feel confident. You feel ready. You feel lucky. Time to start trading, right?

Despite these seemingly auspicious beginnings, most first-time traders lose money and do so quickly, usually within six months. Some are unprepared for the volatility that can appear from nowhere. A telltale sign of this is failing to retain sufficient cash in the account as excess margin. Some fail to invest wisely, spending all their cash to purchase a large number of cheap options, for example. Costs can be significant, for example, if a deliverable contract is held into the notice period.

Others make classic errors with order usage. An example is using a limit order when a stop order would have been appropriate. Still others lose their objectivity at the most regrettable times. Examples of this include moving a stop order to allow for larger loss or adding to a losing position.

Unfortunately, by the time the trader has begun to develop some kind of defense to these pitfalls and problems, usually in the form of hard-earned trading rules, his trading cash is too low to continue. What is needed is a training ground on which mistakes can be made and lessons can be learned without wiping out trading capital. Such an educational tool exists and it’s called paper trading.

Paper trading is fictitious trading, meaning that buy and sell transactions are not carried through to completion in the trading pit. The trader does not have the market exposure of an actual position and does not have the associated risk. However, trades are filled and recorded as if they are real. To be beneficial, a paper trading account should have the following:

Legitimacy. Third-party involvement is important. When people paper trade on their own, it’s too tempting and too easy to look back at a chart and say, “Oh yes. I would have bought there.” Paper trading without third-party legitimacy has little value.
Real-time execution of orders. Market orders should be filled at or close to the market price.
Current margin requirements. Current margin requirements should be used to calculate excess equity in the account, just as if the trades were real.
Realistic execution of orders. Some orders should be returned as “unable” and there should be slippage on stop order fills, just like real trading.
Account statements. Paper traders should see daily account statements that show the trades for that day, open positions, margin requirements and excess equity.
Cost for trading. It’s easy to get carried away when paper trading and buy 25 or 50 contracts at a time. This is unrealistic for most beginners. There should be a real cost associated with paper trading to curb this impulse.
Educational support. You will have questions when paper trading and you will make mistakes. For the exercise to be worthwhile, you need to be able to rely on educational support from a knowledgeable staff.
Flexibility. Most people can’t take time out of their day to paper trade. You should be able to paper trade in the evening and preferably over the computer. Also, you should be able to paper trade for as long as you wish.
Freedom. There shouldn’t be a subsequent obligation to trade for real. After all, if the paper trading reveals a significant shortcoming, then the last thing you should do is commit your hard-earned dollars to the program.

Assuming that the above conditions are met, and provided the trader acts as if the trades are real, then paper trading can be an excellent learning tool.