Paper Trading and the Transition to Real-Money Trading
By Barry Lutz of Tactical Trading, LLC*
Posted: Jun 30, 2006
The merits of paper trading and its relative value to a trader in making the transition to real-money trading have been widely discussed. One viewpoint is that, because paper trading is not real, the profits are meaningless and are no indication of real-money profitability. An opposite viewpoint states that paper trading is an important step in the trader’s learning progression, and, regardless of whether it is real, if the trader cannot “properly” paper trade, he or she will not be able to real-money trade.
I began trading in early 1995 with the intention of becoming an options trader; my first trading education was through an OEX options teaching service. Besides options training, the service included “tape” reading, trade management AND S&P 500 index futures trading. Also included in the service was the prevalent attitude that paper trading was for “sissies”.
So, I was a new trader, trying to learn and understand completely new concepts and ideas -- what was called a trading method -- AND I was “practicing” with real money -- because paper trading was for “sissies”. What did I accomplish, besides a big draw-down in my account? I was quickly introduced to trading psychology and the related implications -- something else I also knew nothing about.
I lost money and became a trading psychology “wreck”, both from the losses and because of thoughts about how I was too “stupid” to ever learn how to trade. This combination took me out of futures trading, and, then, unfortunately, carried over into my options trading, which I had previously been doing well with. I just couldn’t take it anymore -- I had to start all over somehow or just quit for good.
Paper Trading ViewpointsConsider this: Simulator fill prices are not real and won’t be attainable with real money. Even if this is correct, is it really an issue unless the trader intends to be a scalper, trading for very small profits, and, thus, each tick is critical? Granted, but shouldn’t a beginning trader be very selective, focusing on learning his or her method and the “best” setups that method provides? This would be my viewpoint, and, in this capacity, paper trading fill prices are not an issue.
Consider this: The trades are being done with no risk. No, there isn’t any financial risk in paper trading, but I actually haven’t met nearly as many profitable paper traders as one might expect. Why would this be the case if being able to trade without risk were such an easy thing to do? As well, what about self-esteem risk and an attitude such as this: How can I be so bad that I can’t even paper trade?
The fallout from risk feelings like these is probably greater than that of financial risk, and, if they are going to surface, you would want to encounter them before trading real money. As well, even if the issue were only one of financial risk, wouldn’t you want to begin with the confidence of knowing that you were paper trading profitably? It would be hard to imagine a losing paper trader being able to profitably trade real money.
Consider this: There is no emotion involved in paper trading. I was in our chat room watching a paper trader post trades in order for me to give feedback on them, and I noticed that one of the specific plan setups wasn’t done. When I asked why, the trader told me that he / she was ahead for the day and didn’t want to risk those profits. But, the profits aren’t real -- how can you not take a “base” method setup when paper trading -- isn’t that the point?
Would you be in agreement, that, if paper trading profits could be viewed in this fashion, it has the ability to become very real and thus emotional to the trader? I would suggest that this is related to paper trading really not being “so easy”, and, as mentioned above, self-esteem risk can a major impact.
Besides examples like these, emotions can be added to the paper trading process. Throw away your simulator and then go into a chat room and post all of your trades -- no “youknowwhating” around where you wait to see if the trade was profitable before you post it as with a number of traders I’ve seen. What’s the point? When you consider the underlying implications of “needing” to do this, the issue certainly isn’t about whether paper trading is of value or not but, rather, about how it’s certainly best to find these things out before trading real money.
You must post immediately and without delay, giving your direction and entry price, along with subsequent posts of any partial profits, and, of course, your exit, which, ultimately, is the determiner of whether the trade was profitable. There is no need to make any comments or answer any questions regarding your trades -- simply post the particulars as fast as you can in real time AND see if you feel any emotions doing this in front of the rest of the room while you go through a series of losses.
Do you want to add even more emotions? Go through the same posting process but do so where the rest of the room actually knows the method you’re trading and what the trades “should” be. You will quickly find out just how emotional paper trading can be -- actually a very valuable exercise for the paper trader.
Paper Trading and Making It Further BeneficialI have two predominant problems with paper trading, but they have to do with the trader’s approach and not with paper trading by definition:
- Traders do “things” while paper trading that they would / could not do with real money.
- Traders view paper trading profitability, instead of paper trading proficiency, as the guideline by which they judge their readiness to begin trading real money.
I have seen too many paper traders, continuously and knowingly, overtrade “non-plan” trades with trading size greater than they could afford the margin for in a real account, let alone accept the risk of loss for, while also holding trades for risk amounts that they would not accept with real money.
If the paper trader views paper trading as a “step” in the learning progression and transition to real-money trading, he or she will only trade exactly what and how that trader would using real money. Don’t allow yourself to turn paper trading into a game because, supposedly, there is no risk. The risk of getting into bad habits you can’t correct is tremendous.
Paper trading is the time to learn YOUR basic trading setups and make necessary adjustments to them and your entry / exit timing so that you can, then, make money trading them. It’s NOT the time to turn your simulator into a pinball machine, flipping at any ball that comes near you.
There is a problem with focusing on trading profitability versus trading proficiency. To begin with, profitability places the focus on money instead of plan. And, what is profitability? If you take 10 trades and make $75, are you profitable? Technically, if you are net ahead, you are profitable.
But, what if those same 10 trades had a potential of $1,500, and you only made $75 -- then, are you really profitable? This is what I am referring to when I talk about trading proficiency. Instead of focusing on the common metrics, such as win:loss or win size:loss size ratios, I am most concerned with the win size:potential win size ratio and maximizing this percentage to the extent possible.
For instance, when traders ask about adding trading size, taking the attitude that, if they can make $100 trading 3 contracts, they can make $1,000 by trading 30 contracts, the first thing I ask them is this: What is your proficiency ratio? Why increase contract size and the corresponding trading risk, if you “should” be able to make more money with a smaller size?
This is especially important for paper traders: They should not regard simple profitability as an indication of readiness to trade real money but consider proficiency instead (for example, begin trading real money when they are 60 - 70 percent proficient with paper trades).
So What Is Your Viewpoint regarding Paper Trading?I never thought that I would ever make a dime trading, let alone be able to trade for a living or become involved with trying to teach others to. Was this simply a function of starting over and paper trading? Granted, that is too simple an answer. However, I do know that it would have certainly changed the beginnings I had while very much shortening my learning curve and reducing the amount of pain I suffered.
Clearly, I am on the “side” that believes that paper trading is, not only beneficial, but even necessary. However, its value is dependent on the trader’s approach and attitude. Needless to say, paper trading as I have described it is something I have always strongly recommended.
*Reprinted (and modified) with permission from Barry Lutz of Tactical Trading, LLC (www.tactrade.com)
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