Why Paper Trading Is Counter Productive

by StockTeacher.com

Paper trading is the biggest mistake that new traders can make. This is the most counterproductive way to learn how to trade properly. When paper trading, every single trading decision is based on zero emotions. You are actually training yourself how to decide entry and exit targets based on no risk. It is a fact that the greater the risk, the greater the reward. As paper trading has zero risk, it has no reward. It will actually increase your risk to gain reward when you start to trade with real money because you have been teaching yourself how to make decisions that do not apply in the real world. When you start to make these decisions in real life, it will be financially devastating.

In order to trade properly, traders must possess 100% technical skills, but they only need to apply 15% of these skills when trading. The other 85% of the equation is keeping their emotions under control. Trading profitably is 15% technical and 85% emotional. So how do you keep your emotions in check?

To do this, you must determine how much money to risk during the learning curve that makes trading a productive and educational experience. We do not suggest that you risk all your capital on each trade to make sure that you are ?emotionally trading the markets.? As individuals, we all have a different financial situation, and each person will have a specific zone where a certain amount of money at risk triggers a specific amount of emotion. Do you think a person with risk capital of over $2 million is going to be emotional with $100 at risk? If this person buys 100 shares of a $20 stock and the stock trades down to $19, is he going to have any emotions? I am sure that if he owned 10,000 shares in this situation, there would be a large number of emotions involved, probably too many emotions.

No one can speak for another individual?s emotional level. What each of us must do to make trading educational is to find our ?emotional risk level.? I have a friend just starting out that trades a $25,000 account. He finds that a loss of $100 creates an emotional environment and $70 to $130 is his emotional risk level. When this trader is risking $50, there is not enough emotion. When he risks $500, there is too much risk and his emotions are too powerful for him to think clearly and to make proper decisions. After this trader had a month of experience, his emotional risk level increased so he was comfortable, yet still emotional, when risking $400.

The secret to educational and profitable trading is to closely monitor your emotional risk level and change your actions as necessary. This can also mean lowering your risk capital. My friend who was comfortable with $400 had to lower this amount to $300 after he and his wife found out they were pregnant and decided they needed to buy a house because their rented apartment was too small. This added more financial responsibility, and the down payment on their home lowered his risk capital. Numerous variables can come into play and influence a person?s emotional risk level, and only you can judge where this level should be. No one knows your situation better than you do.

For those who are completely new to direct access trading, paper trading can be helpful only when you are learning the software platform. It is not wise to begin trading with real capital while trying to learn software. If you do not know how to set up charts, watch lists, order entry, hot keys, and if you are not familiar with the Level 2 screen, trading in demo mode is recommended when you follow a specific set of rules. Most demo accounts allow you to trade with a $1-million account. They also provide you with fictitious order fills. So in order to learn properly using a demo account, you must follow these guidelines:

1. If you will be opening a $50,000 trading account, make sure that the demo account size is $50,000 and not the standard $1 million. Ask your broker to change the default demo amount to your actual account size. The reason is to make sure that you do not get used to risking more money than you have. If a new trader is used to risking $100,000 in demo mode, he is more likely to risk too much when he ?goes live? trading real capital.

2. You should trade share sizes that meet your emotional risk level. You do not want to get used to trading 2000 share lots when, in reality, you will be using only 200 shares or whatever amount meets your emotional risk level.

3. Ignore unrealistic order fills that overpay for each trade. Trading simulators will often fill your order at a price that would never happen in the real world. If you want to buy a stock that is currently trading at $20, place your order for $20.05 and when you want to exit, do the same. If the stock moves up to $21, place your sell order for $20.95. This helps the trader get used to real life order fills. You do not want to get used to the paper profits that would never occur in real life.

4. Create real emotions while paper trading. Find a friend to compete against in demo mode. For each point that you win, the other player must pay you $5 and vice versa. (Make sure you place a cap of $100 during your friendly competition.) This helps bring emotional trading decisions into the equation.

As soon as you are comfortable with the trading platform software, stop paper trading and start trading live, but make sure you stay within the lower limits of your emotional risk level during your first week. You will become a successful trader more quickly trading in live mode than if you trade in demo mode. Continuous paper trading will decrease your odds of successful trading because after doing something repetitive, it becomes instinct. Trading an unrealistic account size, unrealistic share sizes, getting unrealistic order fills, and trading unemotionally with no real risk repeatedly will provide you with instincts that are useless and counterproductive. When you decide to trade live after paper trading, you will actually trade at a level below someone with no experience. Before you can advance, you will have to shed all of your bad habits.

It's very true that trading real money creates new psychological issues, and that establishing one's emotional comfort zone, in terms of risk, is a crucial part of the learning process. But I nonetheless believe that having complete confidence in one's system is equally imperative – especially if one is going to maintain discipline during periods of drawdown – and demo trading is arguably the best way to achieve this confidence. It brings one a significant step closer to real life action than does back-testing.

I note that Jim (creator of the James16 Chart Thread and private forum) recommends trading profitably for a period of months in demo, before risking real money.

Top professional sports people constantly practise their activity, in training sessions, away from any "superbowl" match atmosphere. If you can't get it right during the dress rehearsal, when there is no pressure, then you're never going to get it right when the pressure is really on.

I believe that the analogy is a valid one. It's easier to evaluate one's system objectively when there is no emotion involved. Starting immediately with real money can make it difficult to make the important distinction as to whether any failure lies with the method itself, or its implementation (i.e. the psychological area).

Having said this, though, given that there are brokers offering micro-lots, the impact in transitioning from demo to live trading doesn't have to be a sudden one. One can start live trading very small, and grow gradually, as all of capital base, confidence and experience justify it.

At the end of the day, the aim is to attain complete emotional detachment, in so far as this is humanly possible, and this can only be achieved by playing for stakes that one is totally comfortable with, at every point along the journey - even if this means sizing positions significantly lower than the 2% rule.

How can anybody say categorically that trading is 15% method and 85% psychology? Given that emotions can't be measured mathematically, why not 10%/90%, or 20%/80%? Surely the real answer varies for each individual. And, faulty method will cause loss every bit as much as indiscipline: in this context, both are equally important.

So long as one is aware that live trading will create additional psychological (and potential slippage) issues, and sets expectations accordingly, demo trading doesn't have to be counter-productive, as the original article's title states. In terms of learning the mechanics of trading, and gaining objective confidence in one's system, it can be an extremely valuable step in the overall path.

David

[Edit: one final point. In the case of paper trading, obviously for it to be of any value, one must trade as accurately, decisively, and as realistically as possible. If one changes signals, or makes trades, after the event - one is only cheating oneself.]

Hanover makes some great points.

While I agree that emotions come into play in a big way when trading live, I feel that the main idea of paper/demo trading is to learn HOW to trade to start with.

Paper/demo trading should be used to get familiar with the mechanics of trading, the indicators being used, the system, etc.

Then, once the trader goes live, the focus can be on controlling emotions, since the trader has already learned HOW to trade.

I think that going live right away puts too much pressure on a new trader, as they are trying to learn everything at once and deal with their emotions at the same time.

Too much stress usually means the trader will give up when, had he paper/demo traded first, he would only have to deal with one thing -- emotions -- when he goes live.

Having said that, Hanover's suggestion of micro lots would help to alleviate this problem.

This profession takes guts. I compare it to seafaring the old way. Nothing but sheer grit will keep you holding onto your ship when waves are breaking over the bridge. Some ride it out to fortune. Many more go under. You can't be right all the time.

I rather see it as

when paper trading, you kind of try out tricks and take semi risky trades.

But when you are trading for real, you got to be very careful and take trades which you are confident of only .

When u suddenly shift from paper trading to real trading , you forget the above and take trades which u are not fully confident about.

So u end up biting ur nails, cutting ur profit too soon etc .

Hanover's post is clearly of higher quality and understanding of trading than the first post.

The comparaison with sport is I think is excellent. It is the repetition of the action in training that makes that you can repeat the same action under pressure because it becomes almost "instinctive"

If you don't have an edge, you can control all the emotions you want you won't make a cent. Like even if you would be able to ignore the pressure of sport events, you would still need first to be skilled (much more skilled than average).

I think that what is counter productive for newbies is to read such kind of articles (and other ones that sometimes over-emphasized MM even if both psychology and MM are very important). It looks like if you control you emotions and have a good MM money will flow. But that is absolutely wrong. First you need an edge.

So instead read what Hanover has written it is much better.

No offense, but "Trading takes guts" is one of the most ridiculous cliches out there. This is a pathetic excuse to make people feel better about it in my opinion.

I will ask this: What takes more bravery and guts?

Trading GBP/JPY? Or hanging off a 40 foot ladder? Or how about 100 feet of scaffolding? This is all in a day's work for me, at times.....

Traders are basically sissies, it's a matter of "Manning Up" that most traders lack. As soon as I got over the fact that not all trades are winners - it became rather easy.

Sorry mate.....it's not directed at you - but I HATE that statement. Being a kid in the slums of Rio takes guts. Being a forced child soldier in some forgotten African civil war.....that takes guts.

Losing a few hundreds dollars is something I can do in a bar anyways.