It has long been said that in order to become an expert, you will first need 10,000 hours of practice. Though this number is obviously a rough estimate—and will vary tremendously depending on what you are doing—there is no doubt that practice is a very valuable thing.
In the world of trading, the need for practice is especially important. Without a strong familiarity with market mechanics, various financial assets, and technical indicators, you will quickly find yourself losing money. Even if you don’t have 10,000 hours to spend practicing and fine-tuning your trading strategies, making a conscious effort to familiarize yourself with the market in advance will pay off in the long-run.
In order to prepare for big trades and maximize their average rates of return, many traders will begin by trading in a simulated environment that allows them to experiment without actually risking any capital. Then, once they believe their trading strategies are ready, these strategies can be tested out on the actual market.
This form of practice trading is frequently referred to as “paper trading”. In this article, we will discuss the importance and meaning of paper trading, how to efficiently use your time as a paper trader, and how paper trading can be specifically applied to the options market. By taking the time to hone your trading skills in advance, you will put yourself in a position for success.
What is paper trading?
Paper trading is a term used to describe various methods of simulating a trading environment, without requiring traders to commit any actual money. There are multiple different uses of paper trading. Some individuals will trade on paper in order to familiarize themselves with trading as a whole. Others will use this technique to test different trading strategies.
The best paper trading systems will make it easy for traders to backtest their approach using the historical record. This way, instead of waiting for new data to emerge, traders can immediately see how a position would have fared if it had been entered into at a specific point in time.
For example, a paper trader might have a new swing trading strategy that wants to make sure is protected against the risks of a pending recession. While paper trading, they can “go back in time”, pretend to purchase shares of a specific stock in 2007 (following a swing), and see if that stock would have increased or decreased in value. This will signal to traders whether their strategy is moving in a productive direction or if they need to go back to the drawing board.
How can I get started paper trading?
There are many different paper trading platforms available for you to choose from. When comparing the paper trading options you have available, make sure that there is a sizable dataset available that allows for backtesting. Other features to look for while comparing include the use of live market data, the ability to test different price points (opening, closing, midday, etc.), the use of different financial assets (such as options), and the ability to hold positions of different sizes.
Most paper trading platforms are similar to one another, though it will still be worth your time to compare your options. We recommend using the platform Thinkorswim. ThinkorSwim has an innovative, free (for 60 days) platform that is easy to use and is incredibly flexible. The platform is supported by TD Ameritrade, allowing it to have access to the historical data it needs in order to be useful.
How can I effectively use the time I spend paper trading?
Because the window for free paper trading on platforms like Thinkorswim is usually limited, you will want to use your time as efficiently as possible. In order to develop an effective paper trading strategy, you will need to do a considerable amount of planning in advance.
- Identify Potential Trading Constraints: things such as the marginal cost of trading, time constraints, and capital restrictions should all be identified in advance.
- Choose a Few Favorite Technical Indicators: technical indicators are a crucial part of almost every trading strategy. When trading options, paying attention to the relative strength index, Bollinger Bands, and moving averages will be very important.
- Open Realistic Positions: the purpose of paper trading is to prepare you for the real world. Though it can be tempting to be reckless when you’re not risking real money, opening realistic positions will help you develop a more productive skillset.
- Back Test your Strategy in Multiple Scenarios: even if purchasing 10,000 shares of XYZ stock in 2002 would have been a good idea, that doesn’t necessarily mean your strategy is fool-proof. Testing your strategies in multiple settings can help you be more confident in your final approach.
There are no substitutes for experience and education. The more time you can commit to paper trading, the more prepared you will be once it’s time to actually enter the market.
What are the nuances for paper trading options?
Options are contracts that allow you (but don’t require you) to purchase or sell an asset at a specific price at a specific point in the future. Options contracts typically move along with their underlying asset, though the options market itself is still unique in many ways.
The best paper trading platforms will make trading options as easy as trading stocks or any other financial assets. However, there are still quite a few nuances that need to be accounted for:
- Options Markets are Inherently Volatile: options experience wider price swings than their underlying assets, resulting in higher risks and higher potential rewards.
- Options can be used for Hedging: options can be used for limiting the potential downside of a position and are excellent risk-management tools.
- Options come in Many Different Forms: call options, put options, hybrid options, and other options all cause this particular market to be inherently more complicated.
Options trading is generally more difficult than stock trading, meaning you may need to spend some extra time trading on paper. Don’t let FOMO deter you from getting the experience you need to be successful.
Just as you wouldn’t let a doctor, a pilot, or any other professional operate without any experience, traders require experience as well. Though there may not be a “trading school” like there are med schools and law schools, paper trading gives aspiring traders the experience they need. After testing your strategies on paper and making an effort to better understand markets, you will find yourself in a position to succeed.