Everyone's a Genius When They Paper Trade

I recently set down a number of new positions in the market: three long, one short (via put options). More on these later.

Spending as much time as I do pontificating on subjects in this blog, the experience reminded me of an article on paper trading a friend sent to me a while back. I have excerpted the best parts of the article below, originally from InvestmentU

Everyone's a Genius When They Paper Trade (D.R. Barton, Jr.)

I've heard countless stories of people who racked up fantasy fortunes while paper trading. There's nothing wrong with that. The problems come when people put real money in the market after their magical run-up in the paper world. Let's look at why paper trading often does more harm than good.

Trading too big, too soon. The place where I believe that paper trading does the least to prepare a trader is in the area of tradecraft. I consider position sizing and trade execution to be parts of this broad area. The #1 problem with paper trading is that it gives people a false sense of security. They see huge profits racked up and then jump right in with huge positions, looking to grow their account as quickly as possible.

It's also easy to see that paper trading does little to help you learn the execution side of the business. Learning a trading platform and how to enter orders is not rocket science. But almost everyone I know (including me!) has hit the buy button when they meant sell or vice versa, or entered 5,000 instead of 500 shares. These kinds of mistakes cost real money. But the real execution costs that are not captured in paper trading are slippage (the difference between the price you wanted and the price you actually got) and the cost of not getting executed at all. While these costs can be estimated in paper trading, most people don't have a good feel for the effect these costs have on the bottom line. And until you get caught trying to get out in a fast market that's moving against you, it's hard to really understand the frustration of watching money slip away.

Trading psychology - you can't learn to control your emotions if you never have any. In the area of trading psychology, paper trading falls far short as a teaching tool. You really won't know how it feels to trade until you have some money on the line. There is a huge difference between writing down a trade on paper and seeing it move against you, and watching a real loss rack up against you. Many people feel that the most important aspect of trading and investing is maintaining discipline through the emotions that are generated while trading. You just don't get even 1% of those feelings when you are paper trading.

And speaking of discipline - when paper trading, it is far too easy to fudge the data, give yourself favorable fills, play the "I meant to do that" game and take advantage of other hindsight biases that make your trading results much better than they would have been in real life. Let's face it, when paper trading, we yearn to succeed. We want to prove how smart we are, and that we can conquer this difficult task. And this leads to conscious and subconscious bending of the rules. And all of the problems that come up in real trading can easily be overlooked by skipping an entry on the trade log or by a quick flick of the eraser.

I think these points are great, and I hope you enjoy them. - Ed