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Why Should You Paper Trade Options

July 12, 2018

“Will you skydive without knowing how to operate your parachute?”

Investing and Flying are similar, in some ways.

Many new traders doubt if Paper Trading is still relevant? does it do any good at all. They claim that it is a different “feel” when your actual hard earned money is at risk.

“Your emotions are your biggest baggage when it comes to trading and investing and so you need to go through the “real-pain or gain” to know “how it feels like” to be a trader”…many think that way…

There’s no denying on “feeling part”; albeit, emotions is just one aspect and in my opinion, it is not very important while you are beginning to learn trading. It’s importance, however, grows over time.

So why should you pay attention to paper trading? why is it still relevant and will continue to be relevant?

I trade on paper money even now…why?

Let’s categories the reasons into four broad categories:

 

To Know The Trading Platform

If you think education is exepnsive, try ignorance. – Derek Bok

When you want to drive a car, you need to understand your car’s operations. You need to know how to start, stop, drive, turn, reverse, park etc., and the list goes on and on. Similarly, in order to execute your trades, you need a trading platform which is usually provided for free by your broker who opens your account and allows you to trade.

And guess what, you might have wonderful ideas, trading systems and strategies, but you can only execute those if you understand the trading platform.

So what are some of things you need to learn before you could place your first REAL-MONEY trade?

  1. You need to understand your account information which includes deposits, withdrawals, current balances and so on.
  2. You need to learn how to analyze, open, monitor and close positions for your desired trading srtategy and system.
  3. Trade identification is one of the first areas you will have to spend time on so knowing how to find, filter and identify trades on your trading platform will be extremely useful.
  4. And if you are like most traders, you would want to watch market action and create watchlists, stock filters , etc. for keeping an eye on potential future opportunities.

This is just the beginning.

As you can see, you don’t wanna experiment all this with real-money.

By Paper trading or simulating real-trading environment on a virtual trading account, a newbie trader can avoid painful mistakes that are often triggered due to trading platform ignorance.

 

To Understand Options Better

Options are different. Different from stocks, forex and other financial instruments that you might’ve been familiar with.

In order to avoid single biggest mistake that new traders commit when they start trading options, I suggest that you may want to read TOP 10 things about options. This will provide you with a primer on what is an option, call option, put option, option buying, option selling and some other characteristics of options such as expiration date etc.

Trading options usually involves more steps then simply buying and selling shares. The option price also changes differently to different market conditions. Paper trading first will help you understand how options are different from other instruments.

 

To Manage Yourself Better

Prove you can follow the process first, commit capital later.

Just like any other other business, Trading business also involves a process. And process is best summarized via your, lets call it, standard operating procedure (SOP) that lists who you will find, filter, enter, manage and exit a trade.

Before you commit to real money capital, you need to show, prove to yourself that you can actually follow your own trading systems and strategies. Notice, I didn’t say Profit & Loss; for a new trader learning and mastering the whole process is more important.

Do you do proper preparations? do you have patience, persistence and perseverance to follow through your complete trade’s process?

Paper trading thus becomes an invaluble tool so you could check your discipline and adherence to your trading plans. The more you practice your trading process on paper money, the more painful mistakes you will avoid in future.

That leads me to emotional aspect of the trading process.

There are two very powerful human emotions that can affect the outcome of your trading results massively. Fear and Greed.

“Trading without emotions requires 3 things. Practice. Practice. Practice.”

Let’s go through a recent example:

US Markets have been running a wild rally for a long time. Going up and up and turning into a parabolic rally in Dec’17 to Jan’18.

Look at the chart below; while witnessing a parabolic rally compared to the mild rally over the last year, one should unemotionally start reducing long positions, even though the crazy rally could have made you more money had you kept your long positions for just a little longer.

Experience makes you appreciate that although in a bull market the probability of continuing the trend is greater than stopping for a correction / consolidation / ugly crash, it doesn’t mean that the unlikely will not happen — unlikely is not equivalent to impossible.

Thus, veteran traders would have begun to reduce their long exposure.

It is the experience and the appreciation of risk that empowers these traders to survive and become veterans.

This is what happened next. The Dow Jones Industrials Index dropped over 2500 points in a matter of days, wiping out the whole parabolic rally and some more!

Though Dow Jones has recovered much from it, the deep dive has wiped out many traders with emotional bias such as “This is just a pull back”, “I shall not quit at the darkest hour before dawn” — Market remained irrational just for a few days, before they could remain solvent.

Let’s take PP33 (a powerful strategy taught in OptionPundit’s ProfitPath Intensive Program) as another example.

Not every time the stock breaks through the threshold level smoothly, does it? Therefore, experience here comes to aid as it keeps you calm and patient when the stock makes a false breakout or dancing around the threshold levels.

Experience means a large number of trials, a big sample, statistically sound prediction.

Thus you could sit calmly when the stock is going sideways or going against you — you understand such cases are bound to happen, and they are not the ones (that make you money)! So you will and give them up and give yourself a break, rather than feeling a little frustrated having to cut loss short on the false breakout.

How to get the large amount of experience without financial ruins? You know it now.

With paper money, you will gradually stop thinking profits and losses as tangible stuff such as an iPhone, a camera, a month’s rent or salary. When you stop thinking money as stuff but multiples of risks involved, you are closer to emotionless trading.

Examples:

  • I risked 1R (100% of risk parameter, which could be 5% of account size) and made 3R.
  • I risked 2R and cut loss at 1.7R, etc.

Since it is not real money, you:

  • stop wanting home runs in one trade because the fake profits don’t get you better houses or cars.
  • feel OK to obey the rules for capital allocations
  • feel OK to cut loss and cut loss short.

Before you know it, these practices become habits and then become you. The idea of “show hands”, “be tough and hold on” stop occurring to you. Then your trades look like these, managed losses and occasional great wins…

With enough practice, You become extremely impatient with losing trades but very patient with winning trades.

Wouldn’t you like this? — I hope someone told me these words when I began trading!

 

To Develop A Trading Edge

Now, lets move one of the key reasons I still paper trade.

Market dynamics change, and so do the market internals. Being an options trader, my trades are structured and designed as per my biases around Delta, Gamma, Theta or Vega.

Whenever I have an untested trade idea or hypothesis, especially one whose risk is undefined or unclear to me, I trade those on paper money. I develop my hypothesis, trade plan, key points to watch out during the life of the trade. I develop comprehensive trading system summary and my scorecard for that new trading hypothesis.

Then I trade that hypothesis. Trade develops through various market moves. I take note and revise my hypothesis, if need be.

I do that again.

Then I repeat the process, all over again. I do it many times before I start testing it with small amounts of real money…and again…before committing large capital to it.

Paper trading or simulating your trades is essential for your long term success in trading. There is no short cut. It can save you from potential emotional disasters and/or financial ruins.

Did you paper trade before diving into real-money trading? What did you learn during paper-trading? Was it worthwhile to paper trade? What will you suggest to a new trader?

4 Comments

  • Greg says:

    Well written. I just tried (for the 1st time) to roll a spread, and messed up big time. Lost $1400 — Paper trading. the experience is well worth the money saved in the future. Must learn the platform before going live!

    • OptionPundit says:

      @Greg thanks for sharing your experience.
      What else did you find useful while trading options in a paper money account?

      What would you suggest to a newbie? what are the things she should practice on paper first before going live with real money?

  • Greg says:

    So, While trading has risks, they are (for the most part) controlled risks. And we are all taught that in any trading course that we might attend. That said. Trading is usually done with a leveraged asset (Equities being perhaps the primary, if not only, exception). Leverage allows gains to accumulate faster. It also allows losses to accumulate faster.

    Trading has many moving parts. Options has more so than other forms of trading (e.g. Stocks/Equities, Futures, Forex),

    Whatever your Asset you are trading, Someone new to an asset needs to understand all of the following *BEFORE* they venture live.

    It is imperative that a new trader:

    1) Understand their platform, understand how to navigate the platform, understand how to enter a trade, understand how to close a trade, and understand how to modify a trade.

    2) A new trader *MUST* understand and implement Money Management / Lot Sizing. This is so often left to a late chapter/unit/day in a course, and yet, it is perhaps one of the most important aspects of entering a trade (not the only, certainly, but Lot Sizing / Money Management will almost certainly define the length of your existence as a trader).

    To that extent, Never use the platforms default account size. Many paper money / demo accounts set you up with 100,000 or 200,000 or even more. That’s a ridiculous amount. If you intend to [eventually] fund your account with $5,000 (or $3,500, or $10,000, or whatever), then set the account size to what you will eventually will fund your account with.

    Next, decide the amount of money you are prepared to lose if you are wrong, and/or if the market decided to go against you (do remember that the market does have a mind of it’s own from time to time!) — This is usually a percentage of an account. Typically, for small accounts (whatever small is), it is no more than 5%. For large accounts, probably closer 3%. Compute your lot size properly. Risk percentage times account size gives you the maximum amount of money to risk on any given trade. When computing lot size, the cost of that lot(*) must not exceed must not exceed the risk money.

    (*) Different types of Option strategies can have different ways of computing a trade’s risk. You *MUST* understand how to compute that strategies maximum risk.

    3) A new trader must understand Risk Management. With Options, *most* strategies have built in maximum loss (Buy Call/Buy Put/ Verical Credit Spread). But. You might want to limit your loss to less than the Maximum Risk. Understand how to do that.

    4) A new trader *MUST* understand the strategy that they are trading.

    5) A new trader *MUST* understand how to read the Account Statement. They need to pay attention to all expenses, not just the P/L of the trade.

    6) A new trader *MUST* track their trades. It is crucial to know your win/loss percentage, and whether you are close to the “advertised” win/loss percentage. It is also crucial to compute your risk/reward ratio (for every $1 risked, what is the overall win ratio). How does *this* compare to the “advertised” ratio ?

    The premise of trading is all in the math. You do not need to have a greater than 50% win ratio *if* your risk/reward percentage is 2:1 or more. On the other hand, if the risk/reward ratio is close to 1:1, then you absolutely *MUST* have a win:loss ratio in excess of 50%, or eventually you will go bust.

    7) A new trader *MUST* have a Trade Plan. Most courses completely ignore this.

    A Trade Plan is fundamentally a business plan.

    A Trade Plan defines what you will trade, how you will trade, when you will trade. It defines the strategies you will use, how to apply them, when to exit.

    A Trade Plan will define your goals. Are you looking for Daily Income, Weekly Income, Monthly Income ? Your Trading Plan will state what your goal is, and how you will achieve it.

    Your Trading Plan will define anything you need to know about the platform you will be using.

    Your Trading Plan will become your reference guide in the early days of your trading, and as you go thru your journey, you will update it. You will add new strategies. You will remove old strategies that, for whatever reason, did not work for you.

    Your chances of success are pretty much less, if you do not have a Trading Plan. You are akin to wandering around aimlessly.

    All that said. A new trader can go directly to live money. Many do.
    All new traders will make mistakes when executing trades, especially as they are learning a new Platform, or a new Strategy. Whether you do this in Demo or Live, the account will go down. If it’s a fake $100,000 sized account, it has no semblance to reality. But. If it’s an account sized to what you intend to fund, watching it go down, yes, that hurts. Because. You know that if you had done that with real money, that loss you just suffered would have been real.

    Once you have comfort with your Platform, executing your Strategy(s), reading your account statement and verifying your performance, then you are ready to go live. You will still have losses. But. From your practicing, you will know to expect them, and if you have practiced Money Management, and Lot Sizing, your losses will be small. From practicing, you will know percentage wise, how many losses to expect, and should be able to survive limited draw downs, and survive. Learning this with real money is an expensive way to prepare.

    • OptionPundit says:

      @Greg, Excellent thoughts. And that’s one of the reasons I say, prove process/profits first, commit capital later. You have some great pointers here that I think will be useful to those learning from this post. Thanks for the builds.

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