Trading is one of the most reliable ways to take a little bit of money and—eventually—turn it into a lot of money. However, as all experienced traders will tell, returns from your trades are not always guaranteed. In order to be successful, you will need to develop a trading strategy that actually works.
In order to hone their skills and test different trading strategies, many of the world’s top traders will begin trading on paper. As the term might suggest, “paper trading” is the act of simulating options trades without risking any actual money. In other words, all of the trades you are making only take place on paper.
Regardless of your current level of confidence, paper trading is something that is highly recommended. Practice makes perfect and, even though you are eager to get started, the risks of entering the trading world without any experience or exposure are incredibly high.
In this article, we will discuss the most important things for you to know about paper trading options. By taking a little bit of time to practice and experiment with different approaches to the market, you’ll be able to achieve your long-term trading objectives.
Record as Many Details as Possible
In order to determine which strategies are effective and which strategies need adjustments, you should carefully record as many details as you possibly can. Simply recording your entry points, exit points, and profit margins will not be enough. You’ll also need to answer several fundamental trading questions.
In addition to identifying these points, jot down why you decided to enter and exit your positions at each specific point. You should also justify variables such as the number of shares you purchased, the specific stocks you chose, and your targeted risk: reward ratio. As time goes on and your number of paper trades accumulate, certain patterns will likely begin to emerge.
Identify your Trading Constraints and Objectives
The trading strategy that makes the most sense for you will depend on your personal constraints and objectives. For example, a day trader (making dozens of trades each day) will have a much different approach to the market than a position trader whose positions can last for weeks or even more.
Common trading constraints include the cost of trading, time availability, and access to certain markets (foreign markets can be harder to access). The mix of your portfolio, including bonds, stocks, and cryptocurrencies, may also need to be considered. Your objectives, such as your desired ROI, will have a huge influence on the strategy that’s right for you. Someone trying to produce 10 percent ROI each week will need to take much bigger risks than someone trying to produce the same yield each year.
Choose a Trading Software that Allows you to Back-Test Trading Strategies
Most paper trading is done with some type of trading software, making it much easier to test your strategies and evaluate their outcomes. One of the most valuable trading software features is known as back-testing.
Back-testing makes it possible to see how a given strategy would have performed over time. Instead of needing to wait for data to accumulate, you can test your strategies against a hypothetical past. While past successes don’t necessarily guarantee future results, they are indeed strongly correlated.
Use Multiple Different Technical Indicators
Technical indicators allow traders to objectively determine whether a security is likely to increase or decrease in value. Though no indicator can claim to have a 100 percent predictive value, using multiple technical indicators will make it much easier to get the results you are hoping for.
Technical indicators come in many different forms. Band indicators, such as Bollinger Bands, help you identify the likely range of a security’s price. Moving averages, the relative strength index, volume indicators, and advanced indicators such as the Ichimoku Cloud will also help make it easier to identify possible entry and exit points.
Try to Understand the Relationship between Markets and Current Events
In addition to choosing a few technical indicators (we recommend selecting at least 3), you should also pay close attention to fundamental indicators as well. Fundamental indicators are real world indicators, such as GDP growth, that are indirectly tied to the changing values of speculative assets.
Trading along with the news is one of the best ways to become a successful trader. While paper trading, compare variables such as the price of crude oil and the value of Exxon stock. By understanding how changes in these fundamental variables affect the assets they are connected to, you can remain ahead of the market. Fundamental variables are especially important when trading forex, where things such as tariffs, central bank announcements, trade deals, and financial reports can immediately influence the value of global currencies.
Be Aware of Hindsight Bias
Hindsight bias is one of the greatest risks of paper trading. It is very easy to look at historic data, think “If I would have done X, I could have made Y dollars” and then assume that the strategy is fully protected against the future unknown.
Hindsight bias can cause traders to wrongly assume a given strategy is invincible or assume that an approach to the market is much less risky than it actually is. While this common bias does not negate the benefits of paper trading altogether, it is certainly a trading hazard that you should make an active effort to be aware of.
Continue Paper Trading throughout your Trading Career
Contrary to popular belief, paper trading isn’t something that is reserved solely for new traders. Just as professional baseball players still go to the batting cage on a regular basis, even experienced traders can still benefit from paper trading.
In addition to trading in “real life”, many experienced traders will trade parallel on paper. This makes it possible to test new, possibly riskier strategies and compare the results to the strategies they already have in place. Paper trading will also make it easier to test the effectiveness of new technical indicators.
Before you risk any of your hard-earned money, take some time to experiment and begin trading on paper. With many free varieties of paper trading software available to choose from, practicing and honing your trading skills is more accessible than ever before.