Should You Be Paper Trading Stocks Right Now?
It doesn’t matter which market we’re talking about and paper trading still applies. Be it stocks, bonds, options, futures or forex. Whether new to the game or a seasoned veteran, all investors should consider some form of paper trading in their account.
One might ask, what is paper trading?
It’s just like regular trading, but without actual money on the line. Essentially, it’s simulated trading. Assuming a quality program, investors still see real prices, real orders and real spreads. But what’s the point of trading without real money? The point is to hone a new strategy, work out the kinks on an existing strategy or learn the ropes.
Some traders do not like paper trades. They say that without skin in the in game, new traders treat simulated trading too much like a game. They aren’t invested in the process the way they would be if their real, hard-earned cash was on the line. To a large extent, that’s true. But that doesn’t mean paper trading should be completed avoided.
In fact, it doesn’t matter what level of trading the investor has under their belt. Paper trading has its benefits and that means it should at least be considered.
Why You Should Consider Paper Trading
Consider a brand new investor. Someone who doesn’t even know how to place a buy/sell order or know the difference between market orders and limit orders. Do you think they should go right to live trading? Of course not!
Paper trading offers a platform that allows them to get comfortable with trade execution. It may also allow them to get comfortable with specific stocks and certain strategies.
Experienced traders with proven systems can also be big beneficiaries of paper trading. Some traders have a system that works quite well, churning out consistent gains month after month. But what if a small tweak — an adjusted stop-loss or different order quantity for high-probability trades — made an improvement to their system?
If the trader can run the two systems side by side, they could observe the differences in real time, as well as over a set period of time. The current system would run on a live account with real funds, while the new system would run on a paper trading system. This would allow the trader to determine whether the tweaks were worthwhile or whether they should be discarded.
I have personally seen some rather successful traders implement a strategy like the one above. I’ve also witnessed traders with a successful system in place who paper trade a new system to make sure it’s worthy of putting real money behind.
Finally, when some traders hit a rough patch in their trading, they can head back to simulated trading for a few sessions to get their “edge” back.
The Drawbacks to Paper Trading
As with most situations in life, everything has its drawbacks. Paper trading is no exception. When investors are live trading, it’s not always a guarantee that their order will get filled or that their entire order will fill. In paper trading though, so long as the price hits the “paper order,” the full trade will fill.
That can give paper trading investors a false sense of confidence in their strategy. This is particularly true in high frequency trading or with securities that have low volume.
Aside from a false sense of security with order fills, investors have to deal with the potential of overconfidence. Without real emotions or real money invested in the paper trading strategy, investors can get lulled into the idea that the system is better than it really is. Further, can they execute their strategy the same in a live account? If they can’t, the trader may very well be susceptible to cutting winners early and letting losers run.
There’s also the question of time. How long do traders test in their paper trading account? A few weeks or months may feel like long enough, but it could really be the strategy just hitting a “sweet spot” in the market. When conditions change — going from a trending market to a choppy one or going from low volatility to high volatility — perhaps the strategy does terribly.
Finally, while some systems do, most paper trading accounts don’t account for commissions. While not a huge component to the bottom line, commissions and fees do add up over time and are rarely accounted for in paper trading.
Paper Trading With Options
With that said, investors have to decide whether paper trading is best for them or not. Clearly, the pros outweigh the cons so long as investors are aware of the key points going into it.
Earlier we mentioned that traders may consider using a paper trading system when getting into new securities. Just because someone is new to options or futures does not mean they’re new to trading. Even more so, just because someone is experienced in trading a specific asset, such as options or futures, doesn’t mean they should avoid paper trading either.
They more than anyone already have experience setting a realistic outlook and keeping their emotions in line. In that respect, they’re perfect for simulated trading. With options specifically, there are a plethora of strategies to choose from. Unlike stocks, which are essentially buy and sell orders, there are a dozen or so options strategies and even more “unique” situations that come up every once in a while.
For many, they are not well-versed in all of these strategies and may want to consider paper trading them at first. Be it bull call spreads, credit spreads, dividend capture strategies or other concepts. This will at least give them an idea on whether they have the proper structure to their new strategy. If so, they can make tweaks in their paper account to eventually take it live. If not, they can head back to the drawing board, but at least it didn’t cost them real capital first.