Paper trading

What is paper trading?
Paper trading is a process in which you make investment decisions without committing real money.

You approach a paper trade just as you would a real trade, taking into account everything you would consider if you were making a real investment, and recording your investment decisions on paper. By looking at how your theoretical investments perform you can evaluate how well your investment approach is working, without the pressures of possible financial loss.

Why paper trade?
Paper trading gives you the opportunity to practise, and learn, without the danger of real losses. You can experiment with different trading approaches, and test and refine your trading strategies in practice before applying them in the market. You can observe how premiums move, and get a feel for the effects of time decay.

It is also easier for you to be objective in a simulated trading environment than in the real market. When you have real money at stake, emotional reactions can sometimes cloud your judgement. However, if you practise a detached and objective approach during the paper trading stage, you may increase your chances of using such an approach in real trading.

How to paper trade
You should approach paper trading as realistically as possible. Just as you would if you were trading real money, you need to take into account:

  • your financial resources
  • the amount of time you can realistically dedicate to trading
  • your desired exposure to risk

You will need a source of pricing information so that you can record your trades at market prices. Possible sources of pricing information are:

  • tables of option prices in the financial press
  • free option prices, either live or delayed, on the internet
  • option prices from an information vendor you subscribe to

To begin, you should concentrate on the more actively traded option stocks, and the more liquid option series in each class.

Having formed a view on the market, or a particular stock, you then theoretically enter the position chosen to reflect that view. All trade details should be recorded, just as they would be with a real trade.

On closing out the position, all details should again be recorded and the profit or loss from the strategy calculated. If several different strategies are being tested simultaneously, the results from the strategies can be compared.

Your overall aim is to test the approaches to trading that you are considering. You should set out, in writing, one or more trading plans. The plan should include details such as:

  • profit targets,
  • the degree of loss that will trigger an exit from, or adjustment to your position, and
  • other parameters that define your desired risk/reward profile

Each time you examine your position, ensure that the action you take is in accordance with your trading plan.

Considerations

  • Margin obligations
    When writing options, it is necessary to take into account margin obligations. As these will be incurred in the real market, they must be factored into your paper trading. You can use the Margin Estimator to estimate the margins that would be payable on your written positions.
  • Bid/offer spreads
    When looking at the prices quoted in the financial press or on the internet, be sure to use the correct side of the spread.
    If you are selling an option, the bid price should be used; if you are buying an option, the offer price should be used. When valuing the option during its life, you should use whichever price you would pay or receive in order to close the position.
  • Brokerage
    Brokerage will be charged when trades are transacted in the real market, so should be included when calculating the cost of entering or exiting a position.
  • Risk of exercise
    Any written position that is in-the-money is at the risk of being exercised. For the paper trader, that risk is not real, but it should be considered as if it were.

No guarantee
Paper trading success is no guarantee of success in the real market. It is generally the case that profits are far easier to come by in a simulated environment than in reality. Emotions will be harder to ignore when real money is at stake.

However, if the paper trading process is used effectively, you may increase your chances of success once the real market is entered.