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Investing Articles

Paper Trading vs. Real Trading

This article is obviously an opinion piece. Each trader will likely have their own opinion, and therefore the contents of this article do not necessarily reflect hard and fast rule or consensus.

Paper trading serves a purpose. What might that purpose be? If you have an idea or concept you wish to try out on market prices, and want to see how well it works in real time today rather than using past data, paper trading may be the way to go. It allows you to test the mechanics of your trading method without any interference of emotion. For testing just the mechanics, this will work. However, mechanics alone is far detached from reality, which will definitely provide a completely different result.

Emotion plays a much bigger part in trading than the actual mechanics. Fear and greed weigh heavy on most traders, providing the initial reason for trading in the first place. Think about it. Why are you trading? Is it for money? Is it for fun? Is it for the challenge?

No matter the reasons, it will have a human emotion that was behind the purpose. You simply cannot completely remove it. Paper trading has the side effect of allowing you to stay in a position that is going against you, whereas you might have exited out of fear if it were real money. Paper trading is likely to see more over trading; taking bigger positions that you would not normally take in the real world. These and other actions that paper trading affords skews the results, providing many times a false sense of confidence that you might blindly take into real world trading.

The only real way to know if your approach is going to hold water is in real trading. How do I define this? Simply, if you make real trades using real money, and your gains and losses are real.

Of course, this presents a problem to the new trader. Emotions will be higher than normal for the first dozen or so trades, as the new trader is filled with great expectations of making great profits, as well as somewhat intimidated by the format of trade placement, the broker’s opinion, the speed in which money flows in and out of the account, and so forth. By the time the new trader starts to warm up to this business, their account may be drained.

It is my opinion that paper trading should be brief. Just get the hang of how you would place the orders, and whether you would have been filled or not. Learn to keep a log during this period and when you start trading with real money. Do not be concerned or focus on how much you think you would have made in dollars. Get that out of your head. Just note how effective your method got you in and out of a trade, and if you usually exited with much more points than you were used as a stop-loss, and what percentage of the time you did so. Stick with thinking in points, not dollars.

Then when you are reading to test it in the real world, do not go to the full size contracts. I highly recommend that you trade the MID-AM contracts instead, which is a real money environment, but the size of each contract is small enough to help you preserve capital while you test your trading method.

Stick to a rule of sound money management, especially early in your trading career. For every $5,000 in your account, only trade one Mid-Am contract. See if you can stick to this rule, or whether your emotion of greed gets in the way and you start to fudge an extra contract or two.

Not until you have good control over these emotions should you even think about trading full contracts. If you are honest with yourself and truly want to do well in this business, you won't trade full contracts until you can stick to such simple rules.

Trading Mid-Am contracts is a nice compromise between paper trading and trading full contracts. You can test your approach with minimal exposure due to the small contract sizes the Mid-Am provides. Ordering a Mid-Am contract is no different than ordering its bigger sibling. You simply let your broker know that you want to buy or sell a Mid-Am contract when ordering.

 


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Don't spend too much time on paper trading. Just get the mechanics down, which should only take a few days at the most. Then jump right in there and test your newfound skills using real money and Mid-Am contracts. Stick with this smaller contract until you find your approach is profitable while maintaining good money management practices.

As time goes by, and you find your account is appreciating nicely without breaking good money management guidelines (no over trading), then you may want to go to the full size contracts which offer better liquidity. But when you do, don't stop using those money management skills you worked so hard to hone while in the Mid-Am pits. Start off slow, and trade one contract for every $5,000, even though they are full size now. That simple guideline will work even with the regular contracts.

If at anytime you find yourself slipping backwards due to your emotions or poor money management, go back to the Mid-Am. Don't go back to paper trading unless you are looking to change your method of trading.

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