Paper trading is the biggest mistake that new traders can make. This is the most counterproductive way to learn how to trade properly. When paper trading, every single trading decision is based on zero emotions.
You are actually training yourself how to decide entry and exit targets based on no risk. It is a fact that the greater the risk, the greater the reward. As paper trading has zero risk, it has no reward. It will actually increase your risk to gain reward when you start to trade with real money because you have been teaching yourself how to make decisions that do not apply in the real world. When you start to make these decisions in real life, it will be financially devastating. In order to trade properly, traders must possess 100% technical skills, but they only need to apply 15% of these skills when trading. The other 85% of the equation is keeping their emotions under control. Trading profitably is 15% technical and 85% emotional.
So how do you keep your emotions in check? To do this, you must determine how much money to risk during the learning curve that makes trading a productive and educational experience. We do not suggest that you risk all your capital on each trade to make sure that you are “emotionally trading the markets.” As individuals, we all have a different financial situation, and each person will have a specific zone where a certain amount of money at risk triggers a specific amount of emotion. Do you think a person with risk capital of over $2 million is going to be emotional with $100 at risk? If this person buys 100 shares of a $20 stock and the stock trades down to $19, is he going to have any emotions? I am sure that if he owned 10,000 shares in this situation, there would be a large number of emotions involved, probably too many emotions.
No one can speak for another individual’s emotional level. What each of us must do to make trading educational is to find our “emotional risk level.” I have a friend just starting out that trades a $25,000 account. He finds that a loss of $100 creates an emotional environment and $70 to $130 is his emotional risk level. When this trader is risking $50, there is not enough emotion. When he risks $500, there is too much risk and his emotions are too powerful for him to think clearly and to make proper decisions. After this trader had a month of experience, his emotional risk level increased so he was comfortable, yet still emotional, when risking $400.
The secret to educational and profitable trading is to closely monitor your emotional risk level and change your actions as necessary. This can also mean lowering your risk capital. My friend who was comfortable with $400 had to lower this amount to $300 after he and his wife found out they were pregnant and decided they needed to buy a house because their rented apartment was too small. This added more financial responsibility, and the down payment on their home lowered his risk capital. Numerous variables can come into play and influence a person’s emotional risk level, and only you can judge where this level should be.
No one knows your situation better than you do. For those who are completely new to direct access trading, paper trading can be helpful only when you are learning the software platform. It is not wise to begin trading with real capital while trying to learn software. If you do not know how to set up charts, watch lists, order entry, hot keys, and if you are not familiar with the Level 2 screen, trading in demo mode is recommended when you follow a specific set of rules. Most demo accounts allow you to trade with a $1-million account.
They also provide you with fictitious order fills. So in order to learn properly using a demo account, you must follow these guidelines:
- If you will be opening a $50,000 trading account, make sure that the demo account size is $50,000 and not the standard $1 million. Ask your broker to change the default demo amount to your actual account size. The reason is to make sure that you do not get used to risking more money than you have. If a new trader is used to risking $100,000 in demo mode, he is more likely to risk too much when he “goes live” trading real capital.
- You should trade share sizes that meet your emotional risk level. You do not want to get used to trading 2000 share lots when, in reality, you will be using only 200 shares or whatever amount meets your emotional risk level.
- Ignore unrealistic order fills that overpay for each trade. Trading simulators will often fill your order at a price that would never happen in the real world. If you want to buy a stock that is currently trading at $20, place your order for $20.05 and when you want to exit, do the same. If the stock moves up to $21, place your sell order for $20.95. This helps the trader get used to real life order fills. You do not want to get used to the paper profits that would never occur in real life.
- Create real emotions while paper trading. Find a friend to compete against in demo mode. For each point that you win, the other player must pay you $5 and vice versa. (Make sure you place a cap of $100 during your friendly competition.) This helps bring emotional trading decisions into the equation. As soon as you are comfortable with the trading platform software, stop paper trading and start trading live, but make sure you stay within the lower limits of your emotional risk level during your first week.
You will become a successful trader more quickly trading in live mode than if you trade in demo mode. Continuous paper trading will decrease your odds of successful trading because after doing something repetitive, it becomes instinct. Trading an unrealistic account size, unrealistic share sizes, getting unrealistic order fills, and trading unemotionally with no real risk repeatedly will provide you with instincts that are useless and counterproductive.
When you decide to trade live after paper trading, you will actually trade at a level below someone with no experience. Before you can advance, you will have to shed all of your bad habits.