By John Seckinger*
Paper trading certainly has its advantages, but a trader has to be realistic about slippage and very mindful of proper trade management.
It really comes down to a proper, well-defined strategy that can keep your emotions in check if a trade turns into a loser. That is absolutely the key: Emotional management. I have had many nights experiencing an abnormal (read “fast”) heartbeat accompanied by dreams of some geopolitical event ruining my entire trading account. Is that healthy? No, and I have since learned to be much more “in control” while keeping a trade overnight.
Then, there are the trades that turn into losers, but you feel as if you knew the market and should have made money nonetheless. In those instances, I would then forget the loss and somehow imagine a gain. Not a good idea! Fortunately, those situations were many years in the past for me.
So, how do you paper trade? Bring a pencil and a pad of paper to the computer at approximately 9:00 a.m. (Eastern Time) and put your thinking cap on. If you simply “go through the motions,” you will most likely get a poor education in the reality of trading.
Here is the reality: I enter this trade electronically as the pace of the market is picking up, “Sell 2 ES Contracts at 900, Stop at 904.” After I miss the trade, I change the order: “Sell 2 ES Contracts at 897, Stop at 901.” Then, still without an execution, “Sell 2 ES Contracts at the market.” Filled at 895. Okay, stop at 899. Did this really make sense? I don't think so.
When paper trading, a lot of traders can do the same trade and fill themselves at 900 as the ES contracts print 899. Then, immediately put in a stop at 899 or 900, depending on if the next print is 898 or 900. If 900, a paper trader wouldn’t lose any money and would, most likely, forget about commissions. Plus, there would be no emotions to deal with. The live situation is a very different matter. Making money is hard, so expect challenges.
Okay, so you’ve read all the books, attended all the seminars, and you are ready to make some money trading futures. We all know that only real trading counts for experience, but let us be smart and test a system via paper trading first because that counts as preparation for experience. That does make sense, and so, I paper trade all the time.
What You Need to Remember to Make the Paper Trade as Real as Possible
For example, let’s say that you are starting with $25,000. Remember that each contract bought or sold will have an initial and maintenance margin. For the E-Mini S&P 500 contract, there is $3,563 to put on the trade and $2,850 as a maintenance issue. (Firms will vary on this.) Moreover, every tick (0.25) is $12.50 per contract. Therefore, one point is $50. Open Interest is roughly 400k in the ES, with volume at approximately 550k a day; therefore, we don't have to put a ton of emphasis on slippage (read “bad fill”) unless it is during a time when the market is going vertical.
Please make sure you have a fast computer (256 MB RAM or greater). Fills usually take only a few seconds, and a relatively slow computer really can heighten the odds of your having to reboot it, potentially costing you money.
Also, try not to risk more than a few percent on any trade. If you’re trading with $25,000, 1% is $250 or 5 points. I do like to use 1%, but this is not a set-in-stone rule. Even if you’re trading with a million dollars, I would not use a stop greater than five points unless conditions really warrant such a stop. That said, with accounts 25k or less, try to risk only 1 - 2% per trade. Above 25k, try to keep stops at 5 points or less.
How Keeping a Journal Will Help You Get the Most Out of Paper Trading
Now is also the time to start keeping a journal. You can review and analyze all the trades you have done during the day, analyzing the price and time at which you entered each trade, as well as the time and price at which you exited each trade. You can write down the logic you used to enter each trade, possibly via a chart drawn on a piece of paper (or a screen shot capture if you’re using a trading platform such as eSignal, which includes a paper trading tool).
This journal should help you reduce the number of recurring mistakes and find weaknesses in logic, as well as allow you to process a great deal of information and put it all together. Remember: Be honest with your trading. Here are some questions you might need to answer, “Why am I trading?” “Why is this trade a winner?” “Why am I losing money?” “Why am I repeating negative, destructive behaviors?”
In your journal, here are some things that can be listed: Record Date, Order Number (good to write down because a bad fill can be questioned and referenced more efficiently later), Symbol, Month, Year, Modifier (e.g., At market, limit, stop), Quantity, Filled Price (subtract 0.25 for slippage on both sides of the trade), Long / Short and P / L. Record the initial investment needed to cover the initial margin, as well as the number of $10 commissions for “round trips.”
Here’s another question a potential futures trader can write down: “How soon afterwards was a trade placed once a buy / sell signal was recognized?” The answer to this question is extremely important because being just a few seconds slow to pull the trigger in paper trading can drastically change the scope of the experiment.
Example: I want to sell at 899, and the ES is at 900. Now 899. I check all my oscillators, the Dow, news, etc. and then see the ES tick 898.50. Okay, I sell the contract at 899. What? Not realistic! If you want to go short here, give yourself a fill at 898.25 and then ask yourself if selling at 898.25 is a different trade from selling at 899. Sometimes it is, actually, because a trader’s goal might only be to capture a few points.
In the past, I have put on a trade, lost a few hundred within a few minutes, exited, and then wondered what I could have bought with that money. When paper trading, it is hard to “really” understand these thoughts. Your mind will tell you that you didn’t really lose the money. How can a trader duplicate these emotions? I honestly don’t know. One can only hope that there was a lesson learned concerning why the money was lost, which would mean that there was some slight good that came out of a losing trade. That said, maybe buy a few books on trading after every “hypothetical” losing trade, so some good can come of it.
Why Methodology Is as Important in Paper Trading as It Is in Real Trading
Last, but certainly not least, trade methodically. If you are testing a trading system, but are really only playing around and capturing 0.25 point moves at a time, please don’t trade futures. I have spent at least 9 years trading and 60 - 70 hours a week talking about the market and trying to keep up to date with a system that is profitable. I will admit to implementing some bad ideas, as well as being confident that I had a system that works at certain times in my trading career.
The market is dynamic; therefore, I like to change with it. When starting out, keep it simple, so you will remember what to do when stress really builds. And, trust me; the stress will build. Write down a plan and stick with it for a significant amount of time. Even the best system of all time will have a losing trade, and ultimate success is all about being confident when implementing a plan of attack. If the system fails more often than not, inquire as to why. Ask all your trader friends what is wrong. Treat paper trading like being in school. This is your education. Please take advantage of it.
Let us say that you have been staring at every tick for 5 hours and still no trade. Come on, something is wrong, right? Of course not! I have forced two trades in the last few months and lost thousands. It is not fun. I actually enjoy some days having a system that says, “Don’t trade.” Not trading is so ridiculously hard because it is like going into work all day and then not getting a paycheck after hours in that cubicle.
However, if you try to force a paycheck, then the analogy has you sitting in the cubicle all day AND paying money to do it. The market loves to take money from impatient traders. Don’t be one of them.
*This article is reprinted from www.optioninvestor.com with modifications and permission.
