Why is paper trading important?
People might laugh or balk at the idea of paper trading, they may also fail to understand its value. Take solace in the fact that about 90% of traders fail, so there is a high probability that anyone who gives you grief will be among that crowd. Paper trading is akin to having training wheels on your bicycle. Are training wheels needed to learn how to ride a bike? No, of course they aren’t. But, they would likely save you from some painful educational moments. Think of paper trading the same way. As a professional trader, I can tell you that when testing new strategies, or helping new traders work out flaws and kinks in their strategy, paper trading is the go to method. On what planet would you condone using your own capital to test something via trial and error? I don’t know about you, but that isn’t my cup of tea.
First, let me recommend two brokers for paper trading. Since I trade with Interactive Brokers, I am partial to their software and platform and use their paper account. However, you do have to have a funded account with them to gain access. My second choice would be Think or Swim. While I do not recommend either broker for active day traders or scalpers, due to software limitations, they are both fine places to learn the business, hone a strategy and for swing trading using stock or options.
When a new trader sets out on the journey to learning how to be profitable, they will always encounter hurdles. These hurdles are nearly universal amongst traders. Reading level 2 and time and sales, understanding chart patterns and time frames and learning order setup, execution and timing are all critical to becoming profitable and finding a successful strategy that works for you. There is always more than one way to skin a cat, but you have to be good at it in order to make a living doing it.
So, how does one get good, you might ask? Easy…practice. And while practice isn’t always easy, it is a necessary component of success. Personally, I don’t know any trader that hasn’t paper traded before, at some point before becoming profitable. If you read my recent article on risk management, you will understand that anyone who takes their capital seriously, won’t be practicing with real money. Since risk management is such a critical component to learning profitable trading, it only makes sense for serious traders to practice on a paper account first.
There are literally a ton of websites and gurus out there peddling get rich quick opportunities, the Lamborghini lifestyle and offering simple follow me into my trades to make money ideas. This sounds great and all if you are clueless about how targeted marketing works. In the end, there are really three types of traders. There are the gurus looking to sell you a flashy lifestyle, these types tend to trade the small cap and OTC pump and dump junk. Things they can manipulate more readily with the volume that there subscribers bring to the table. The second type are the professional traders who trade at prop firms, hedge funds or independently and make a great living for themselves without having to sell swag to young adults with raging hormones. The third is probably the rarest, there are traders out there who are not only professional, profitable and successful, but they also have a genuine interest in helping other succeed…without the need for selling a flashy lifestyle. These types tend to let their success speak for itself and form long term bonds with other traders who they help create become successful. I have said it before, just because 90% of traders fail, doesn’t mean they have to. Knowledge is power. And once you set out to learn a strategy from a professional, or even try to develop your own, you would be a fool to not equip yourself properly to succeed in that task. That brings us back to paper trading.
What can paper trading do for you? Learning the basics of the markets, learning to read charts and all the technical stuff that goes into trading is obvious. There is truly no risk to the trader when figuring out things from what layout of charts and indicators you might like to use all the way to configuring hot keys for scalping and learning to perfect your timing and level 2 reading. The most understated advantage of paper trading, in my experience, comes from the confidence building that you get. When you have real capital on the line, you are going to tend to react more emotionally and less rationally than you should. When you are paper trading, you don’t have that emotional connection to real money that you will experience when trading from a live account. This is important because as you learn to build your strategy, you will develop muscle memory and a system that you can see for yourself actually working. Once you gain confidence in those results, it just becomes a matter of applying real money to a trade. It is a brilliant concept that most traders fail to understand or utilize due to their own greed, and wanting to hit the markets running.
I use paper trading every time someone suggests a new strategy to check out, or when I want to test a new scanner I have developed. Without knowing my win/loss ratio and risk/reward ratio when using a strategy, I would be a fool to risk my own capital. The one thing trading has taught me is patience. There will always be another trade, another setup, another press release and another cycle in the market or in a particular stock. Once you have seen the cyclical nature and repetition of patterns for a long enough period of time, it becomes easier to focus on capturing bits and pieces of those cycles. You can’t do that without patience and you certainly won’t last very long if you blindly go into trading with real money.
It is quite apparent that paper trading has more than a few benefits for traders, both new and experienced. But what are some potential drawbacks of paper trading? Well, remember the emotional disconnect that paper trading gives you while practicing and honing your skills? It is also the same reason paper trading can be counterproductive. Let’s face it, there is no way to force yourself or someone else to appreciate money, when there is no risk associated with losing it. So, knowing that, we have to realize that while we may be building and growing our physical skills, muscle memory and even confidence, it isn’t doing anything to help us with our psychological and emotional attachment to our account balance. If you fail on paper trade account, you just reset your buying power and equity and try again. There is obviously no reset button in a real account.
Another issue I have seen from students is the tendency to suddenly break the rules of the strategy and start trading real accounts way more conservatively than they were doing in there paper accounts. They choke out trades, cut off winners, exit too soon out of FEAR that a trade is going against them. They aren’t letting the strategies work and they aren’t giving the trades enough room. As part of risk management, we have to define exits and maximum loss thresholds. Every trade I take, I am willing to lose between $750 and $1,000 depending on the strategy I am using. I didn’t start off with those numbers, instead I grew my confidence from accepting much smaller losses to larger and larger losses. It is part of scaling to grow your account and increase your returns. The percentage of the win should never change if you are looking for high probability trade setups with good catalysts as I have outlined here. As you grow your confidence and mental capacity to withstand the change from paper trading to live trading, you will also be able to grow your account and risk tolerance over time as well.
One tip I can offer for anyone who struggles with the transition from paper trading to live trading is to hide your profit and loss window. Cover it up, close it out, minimize or stick on another monitor out of site somewhere. Once you have found a winning strategy, focus on trading inside that strategy. Trust your stops, your entry triggers and your scale points. Adjust your orders and stops as necessary as the trade moves over time. Don’t watch the profit and loss swings intraday if you are a swing trader, trust the trend. If you start focusing on PnL numbers, you will start micro managing your trades. You will take smaller losers and smaller winners, and you will find over time that you are leaving a ton of money on the table. Every now and then, review your trade log and your goals to make sure you are sticking to your system. Audit yourself and review what went wrong and what went right. Focus on the entry and exit indicators you get on the chart and from your own strategy playbook, don’t let the changing numbers in some window dictate how you trade. Learn to master your risk and become a self-sufficient trader using the plethora of tools available to you.
If you have any questions about this article, trading strategies or even paper trading, please feel free to email me [email protected]