The Case for Paper Trading
The reasons to paper trade as a first step, apart from a brokerage account, include:
It keeps you from the temptation to enter real-money trades before you are ready.
Smart Investor TipUsing a nonbrokerage paper-trading site is a good form of discipline.
- Paper trading with a brokerage could be too tempting. It might seem convenient to open a brokerage account and paper trade for a while, until you are comfortable with a range of options trades. But because real-time trades are also available, it is all too easy to abandon paper trading and go for the money. Without experience in a range of possible outcomes, this could be a costly mistake. It is human nature to fall into a habit of watching the market and seeing opportunities come and go while you paper trade. "If I had only put money into that last week..." is a dangerous and self-defeating way of thinking about options. Remember, on the long side you have to fight the odds because three-quarters of all options expire worthless. On the short side, you need to know what you're doing before entering a two-part trade (covered call) or, even more so, a naked position. This is why you should use a paper-trading service that restricts your trades to the same trading level you will experience when you begin trading for real. When you open your brokerage account, you are asked to fill out and submit an options-trading application, and based on your information and account dollar level, the brokerage firm will limit your trading. First-time traders will be allowed to open long positions only, or to write covered calls; more advanced strategies won't be allowed. To get experience in these advanced ideas, paper trading will be your only initial outlet.
Smart Investor TipAn options-trading application is a brokerage firm's way to ensure that anyone trading options has been screened in advance.
- Using real money before you have experienced the outcome of a trade is risky. Many people begin studying options by reading books or observing the market. But a theory about how a trade will work out is not the same as putting real money at risk. A lot of first-time options traders focus on exotic, complicated, and high-risk trades, so that experience comes at a price, usually meaning losing money. With paper trading, you can try the most exotic, high-risk strategies you want without actually risking any loss. While you should approach paper trading seriously, it does provide you with a risk-free method for finding out the true risk level of a particular strategy.
Smart Investor TipMany options strategies look good on paper. But when you execute a trade, the experience might be far different than you expected. This is why paper trading is a sensible starting point.
- Once you start trading for real, especially using a discount brokerage service, you have little or no support. The advantage of discount services is that trades are executed for very little cost. In fact, the combined cost of opening and closing an option position is usually under a quarter point ($25), sometimes less. This also assumes you trade a single contract. Trading multiple contracts lowers the per-option cost even more. But this savings also comes without any advice or guidance, so you have to find your own way. Options traders, of course, should be able to execute their own trades and also to make their own decisions without help. But everyone needs to start somewhere, and paper trading is an excellent way to begin. Think of paper trading as learning to ride a bike. The training wheels are useful and they help avoid serious injury. At some point, the training wheels have to come off, but not until you are ready.
Smart Investor TipSome investors depend on the safety net of a commission-based broker. But options investors should be prepared to proceed on their own. Paper trading helps you gain experience in trading without the risk and without the advice many investors are accustomed to having available.
- The mechanics of options trading take some getting used to. The very fact that options expire makes them much different from the buy-and-hold strategy of stocks. Many aspects associated with options trading, including margin requirements and limitations, matching of risk with financial resources, and even the details of placing trades properly, all require a degree of practice. For example, many first-time options traders make the expensive mistake of entering a buy instead of a sell, or vice versa. Paper trading helps you to master the oddities of the market by trying out even advanced trades in a simulated environment.
Smart Investor TipThe devil is in the details. Options trading in concept might seem quite easy, but in practice any type of mistake can be expensive. Paper trading is a good forum for making these mistakes.
- Free paper trading on sites selling other products. A site that offers more than mere paper trading is valuable because it lends support to your trading activity, especially if good learning tools are included. Some sites offering paper trading also promote products they are selling. There is nothing wrong with selling products online and, in fact, many marketing sites view free services like paper trading, quotations, and articles as good inducements for traders to visit.
- Subscription sites for options traders. Other sites specialize in paper trading but also offer valuable services as a specific options-related educational service. Many options traders will be willing to pay for paper-trading services because the value in these added services is worth the money.
- Options sites providing paper trading and many other services. A third type of site offers paper trading as well as many other support services, tutorials and articles, and links to education. Because such a site (see the CBOE in the next section) is aimed specifically at options trading, it is informative and full of valuable resources.
By Michael C. Thomsett