Numerous discussions of paper trading, and its value as a learning tool, usually see participants divided into two camps. One claims total uselessness of paper trading, another vows never to start without it. The scoffing camp points out the obvious limitations of paper trading:
Is this all true? Why, of course it is. Does it render paper trading useless? By no means. Paper trading can be extremely helpful if two conditions are met. The first is applying this learning tool at the right time and with the right purpose. The second condition is doing your paper trading right.
Let’s try and build the rules of paper trading that will allow us to turn it into powerful learning tool. We can identify three cases where paper trading instead of live trading is in order:
The first case is the most common. Let’s analyze the right way to structure paper trading for this situation.
Paper trading allows you to ease into real trading and see if your theoretical approach works. It is a stage where you start measuring your method against market movements. You are going to have enough time to deal with the psychological pressure and execution side later on, adding them gradually as you start trading with a small size. However, before real money is used, theory should be checked against the reality, and this first experiment should be as painless for your trading account as possible. Obviously paper trading does not pursue any meaningful target unless your trading system is structured so you can test it; thus, start with constructing your trading approach, then proceed with testing it in real time.
Paper trading is done in a fairly simple way. It is an imitation of your actions without actually sending your orders to the marketplace. You define your setup with all of its components: trigger for entry, stop level, signs of exit, possibly with partial exit and stop trailing. Then when observing the market action you are imitating your responses and writing them down. This is going to be your first encounter with the market so take it seriously. Paper trading will teach you plenty about market action without risking your money if you are watching carefully and acting responsibly.
Observe whether your setups are working. Watch the market action and define if your response is reasonable. If you lose money on paper day-by-day, something is not right with your approach. Try to make corrections, find out what factors have not been considered. This is your troubleshooting stage – look for problems to solve. If you get negative results, do not get frustrated – take them as a blessing in disguise. It’s much better to find out about a problem before committing actual money to a flawed method.
Watch if your risk control is working. Do you lose within your defined limits on any given trade and on any given day? Maintain strict discipline at this stage – your future trading results are going to suffer if disciplined behavior doesn’t become your second nature.
The crucially important purpose of paper trading is to find out the maximum drawdown that you can run into. This element might require a somewhat prolonged paper trading stage. The point here is, losses and wins are not necessarily distributed evenly along the timeline of your trading. You can run into cluster of losses. While the average loss might be affordable in terms of your trading capital, such a cluster may not. It is very important to make sure that a losing streak is not taking you out of the game.
Here are the rules of paper trading that allow it to be as realistic as possible and make paper trading an effective learning tool:
One more purpose of this stage is to get comfortable with your tools. Configure everything as you need it for live trading. Move windows around your screens to have them placed as conveniently as possible. Start with your charting software. Play with the fonts to have all the information that you need on the screen while text is still easy to read. Play with the colors so that different windows are easy to distinguish. Learn to quickly manipulate your charting software. Change symbols, link windows, change time frames – do everything that you will need to do in the course of trading. Draw necessary lines on the charts, add and delete studies and indicators that you are going to use. Do it long enough to make the process automatic.
Learn your order routing software. Manipulate the controls, changing quantity of shares, price of your order, type of order and route. Switch from limit order to market order and back, practice changing the price quickly. Play with controls long enough to make the process automatic. See how to set advanced orders. If necessary, print out excerpts from order routing instructions and place it within easy reach.
Finally, start routing orders in a way that keeps your money safe. Do it in the following way.
Set small amount of shares – from ten to fifty. Set the price far enough from the market price to not get filled. If a stock is trading at $20, prepare your buy order at $10 and short order at $30. Send the order. Observe how a confirmation appears. Now cancel the order and observe the confirmation. Make sure that all the messages you receive become familiar so you do not spend much time reading them later. Make sure that confirmation pop-ups do not get in the way of observing the action. Observe the reliability of your quote feed, especially in the most active periods – market opening produces fast conditions when the quotes are most likely to lag. Make sure that you have trading desk phone number on a speed dial to be able to reach help as fast as possible if something happens to your internet connection or quote feed – no technology is perfect.
It’s often asked how long this stage should be. There is no fit-for-all answer. There are traders that breathe through it in a week, and I know a trader that paper traded for a full year. It doesn’t mean he was a slow learner. He just was perfecting his trading system until he was totally satisfied with it. Although a year is probably a bit on an extreme side, a week or two is not really what suits most people. This is usually not a matter of exact time that would be the same for everyone. Paper trading serves certain purposes, and you should move ahead when those purposes are achieved. Keeping all the rules of paper trading, do you show consistent profit? Have you observed how your setups work and gotten comfortable with them? Have you made sure that you know the drawdown your system can produce and that you can sustain it? Have you become comfortable with your charting and order entering software? If you can answer Yes to all these questions, then paper trade just for a couple weeks more. If not for any other reason, do it to practice one of crucial elements of your psychological makeover – patience. The skill to sit on a sideline will serve you well. It will also allow you to get into your first trading day with more feeling of self-control.
We mentioned two more cases when paper trading is appropriate.
Testing a new system or to tweak an existing one is obviously calling for going back to paper. You are changing something – why risk real money before you make sure it works well? Usually when a trader is doing that he already has enough experience under his belt to know how to paper trade effectively. Just make sure that you give it enough time so your results are statistically significant. I know a trader who does this kind of new tweak testing not even stopping his live entries and exits. While making real trades he simultaneously writes down optimized ones, comparing the results and making conclusions about the quality of optimization.
Going through a losing streak, a trader wants to find out the cause of under-performance. Is it market conditions that change in a way that ruins his system? Is it a trader himself acting in an undisciplined manner? If it’s the market, does something get changed fundamentally or is it a short-lived fluke? Does a major trend change? Is it just a temporary range contraction with no volume? What is likely to come next? These kinds of questions are not easy to answer in the heat of the battle. Thus stepping aside to re-evaluate things, to regroup and to regain your confidence or to re-tune your approach is a good decision.
For whatever reason you go to paper trading, your major step to assure the success of it is to define the purpose and to work out the steps to achieve it.
Reading a lot of "market is not a place for a reasonable investing/trading anymore" comments, I thought I'd chime in and offer my point of view.
To see where I am coming from, consider that I:
- have been trading every day (aside of vacations) for the last 13 years (2 months shy as of this moment),
- made every trading mistake known to humanity and couple I invented all on my own,
- recovered from them after 2 years of learning curve and trade for a living ever since,
- conversed with hundreds if not thousands of traders of all thinkable backgrounds, time frames and approaches.
Here are some of things I see similar in any market, I'll list them and you see if they sound familiar.
1998 - 2000, tech boom, things go higher and higher and higher. Some are happy, making tons of money and talking about "new paradigm"... and some are not, losing their shirt on attempts to short the market, talking about how insane and irrational the run-up is, predicting demise day after day, talking about manipulation and how impossible it's become to trade. There are stocks here and there that turn into cult names, and groups of fanboys cheering them up. XYBR is louded as next MSFT, WAVX is predicted to go over 100, analysts say QCOM should go over 1000 when it trades at 700. KTEL goes from 5 to 20 and 30, and "realists" (your faithful was one of them and paid dearly for that) short it, and it proceeds to 80. Some make money trading what's right in front of them; the rest is discussing how the market should not be this way, trading their beliefs and losing money.
2001 - 2003, tech crash and consequent bear market. Trend reverses, yet permabulls continue buying every new low thinking it's just a pullback (new paradigm, remember?). Market proceeds lower and lower and lower, and seeing the magnitude of drops, a lot of people start talking about selling being overdone. Now it's a move down that is considered insanely big. Each new leg down is being blamed on, guess what... manipulation of course. "Market became impossible to trade" is being heard from every corner. Optimists average down and lose their shirt. Yesterday's darlings start disappearing altogether - simply go bankrupt, delisted etc. Some lucky names get bought out before the final crash, and its the suitors that get killed now. Quality companies lose their value at unthinkable rate - QCOM is nowhere near 700 anymore, and soon loses even 100; a lot of former highfliers go to lows some call insane (NT, JDSU anyone?). Now.... one thing seems to be the same: During all this some traders make money trading what's right in front of them; the rest is discussing how the market should not be this way, trading their beliefs and losing money.
Bull market starts in the spring of 2003. No internet crazies anymore, but hey, there is always a place for "new new paradigm". Market goes higher and higher and higher, and a lot of people say it's insane, housing is a bubble, financials are overblown... and lose their shirt trying to short them... Now, one thing seems to be the same: Some are making money... my reader, be a doll, save me some typing and insert the end of the first two paragraphs.
Housing finally bursts, crash ensues, some of yesterday's darlings go bankrupt (spectacularly I must say), bear market starts. Market proceeds lower and lower, and attempts to buy each new low become common and lead to new bursts of frustration and refrain of "insane, manipulation, impossible to trade". Some are making money... etc, I know, get's annoying.
Market puts a low in March of 2009, and starts making new highs - insane new highs, of course... you can finish this part now without me typing it all.
See some things repeating themselves over and over again? Patterns in who makes money and who doesn't? Patterns in language, in assigning the blame, in finding another scapegoat (day traders in tech boom, "frequent traders" now), in invoking all-encompassing word "manipulation" that makes some feel better but still doesn't help them make money? Patterns in going against the trend, effectively fighting the market instead of being in tune with it? Patterns in trading ones own beliefs instead of market's reality given us in prints on the tape? Patterns in thinking "if something doesn't go according to my belief, it's the market that is wrong but never I"?
See where my favorite motto of many years TRADE WHAT YOU SEE, NOT WHAT YOU THINK is coming from?
"Averaging down" as a trading approach regularly causes controversy. While difference of opinions is always good, let's have a deeper look into it to make sure that opinions are informed and that we are talking about the same thing.
There is averaging down and averaging down. Not all of them are created equal. I'd break them down by two kinds.
1. A trader buys, position goes against him, he fails to cut his losses, sees them growing and getting out of hand. Eventually at some point he adds to his position following the logic "If I liked it at $20, it should be even better at $10" and/or "it can't go any lower". Both are false: anything can and often will go lower (no lack of examples of that over last year, eh?); and who is to say it was any good at $20 to begin with? And is $10 a better price or simply a proof that $20 was a mistake? This kind of averaging down is a "bad" one; it's done out of frustration, and it adds to a mistake. More often than not it increases eventual loss. In most cases what follows is: your position does recover some, by some magic stalling right under new breakeven level ($15 in our example). This gives you a chance to exit with a small loss but you don't take it - after all, recovery has started, you are looking at possibility of nice profits now (and on double size, no less). Sure enough, stock reverses and drops under $10 where you either exit with even bigger loss or put it in your long term portfolio, a.k.a. Grave of Short Term Trades Gone Bad. Another frequent scenario is, stock dives briefly under your second entry level, you sell your second position for a small loss, and that's where stock reverses and goes back to that 15... you curse your decision to cut losses on second part and don't sell first part - after all it's cutting the loss that killed your chance to get out even, right? Sure enough, it reverses down and you are looking at ever-increasing loss again.
Those rare instances when this strategy works only reinforce the idea of it being a viable approach, eventually provoking you to employ it again and again, until it leads you into a loss exceeding anything you saw in your worst nightmares.
2. Averaging down is a part of planned strategy. When a stock comes into your target zone but there is a lot of uncertainty in the markets, you don't feel confident enough to fully commit and don't want to stay on a sideline. You break your purchase in parts and plan a strategy for those parts. This strategy includes various scenarios of building up to full position in a case of further drop, in case of reversal, in case of stall. It also includes an "uncle point" - event or scenario which proves that the whole idea of entry was an error, so whatever is accumulated up to that point is being dumped. There is nothing's wrong with this kind of averaging down - it's done by a design, to minimize exposure at the uncertain time and increase it as events develop in a favorable way. I wouldn't even call averaging down but that's a matter of semantics.
As we see with many other things, there are no absolutes in trading. There is, however, need in clarity, in straigforward well-designed and thought through plan. Such plan, among other things, wil include definitions - as we mentioned earlier in this blog, "as you name the boat, so wil it float".