Chapter 10
Paper Trading: A Test Run of the Theory
Risk is present in all forms of investing. One of the troubling aspects to any new investing idea is this basic risk, and with options the lack of knowledge or experience adds to the overall risk. Anything new you try invariably will involve placing money on the line, even when you lack the experience to know for sure that the concepts will actually be profitable. So anyone new to options trading faces a dilemma: How do you gain experience without placing capital at unacceptable risks? And how do you know if a risk is acceptable until you try a trade for the first time?
This problem keeps many people away from options altogether. Few traders are willing to gain actual experience if that means losing money along the way. Few people will simply acknowledge that loss is the price they pay to gain experience; in fact, the experience you are able to gain profitably is far more satisfying. But even if you are dubious about options trading due to misunderstood or unknown risk, there is an easy solution. You can educate yourself about a variety of trading strategies, even the most exotic ones, by using a free service offered on many financial web sites. This feature, called paper trading, lets you place trades with a fictitious starting portfolio of cash and see how it comes out.
paper trading
online “mock trading” of stocks and options using a hypothetical sum of cash to test strategies in a realistic environment but without placing real money at risk.
Smart Investor Tip
Paper trading works best when it simulates a real-world environment. This should include limitations on portfolio size, timing, risk, and level of transaction you are allowed to execute.
Different web sites offer you a variety of features for paper trading. Selection criteria should include the following:
• Ease of use. The most important feature for any web site is how easy it is to use. No one enjoys having to struggle with a complex or slow web site. Later in this chapter, several sites are reviewed that offer a variety of easy-to-use features.
• Realism. Your paper trading experience should approximate the real trading environment as much as possible. So rules should apply just as they do in your trading account with a broker.
• Trading-level distinctions. In the real world, brokers will assign you a trading level based on your knowledge and experience and also on the cash level in your account and volume of trading activity. A paper-trading web site should provide you with one of two trading capabilities. First, if you use a site that restricts your trading activity, you will learn to function within your level of experience. Second, if you are allowed to execute any risk level of trade, you will quickly learn firsthand about risk and how some options theories end up being very costly. So pick a site that provides you with the level of experience you seek—realistic based on your knowledge level, or unlimited based on your desire to try even advanced and exotic strategies.
• Ability to trade both stocks and options. You want a paper-trading site to provide you with a realistic trading environment, even though you will be making only mock trades. In order for paper trading to provide you with valuable experience, it should be as close as possible to the real world of stock and options trading. You should be allowed to trade both, so that you can experience the cash limitations, risk dynamics, and interaction between stocks and option values.
• Provision of valuable support services. A site offering paper trading is most valuable when it offers additional services. These include educational services, such as publications, articles, and useful links. Many sites have options glossaries or bookstores, links to options market experts, and stock and options quotation services. The more extensive the level of additional services, the greater the value to a paper-trading site.
The Case for Paper Trading
Why should you paper trade? Of course, using a site with many valuable support features will invariably help everyone, but why not go directly to real-time trading? Even if you agree that paper trading makes sense, why not paper trade on a brokerage site? Because some online services offer modeling features to one degree or another, some might think it makes sense to simply paper trade where they will eventually trade with real money.
Smart Investor Tip
Using a nonbrokerage paper-trading site is a good form of discipline. It keeps you from the temptation to enter real-money trades before you are ready.
The reasons to paper trade as a first step, apart from a brokerage account, include:
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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 Tip
An options-trading application is a brokerage firm’s way to ensure that anyone trading options has been screened in advance.
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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 Tip
Many 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.
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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 Tip
Some 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.
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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 Tip
The 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.
There are three types of web sites offering paper trading:
1. 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.
2. 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.
3. 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.
Two Sites Worth Checking
Following are two sites worth checking out. They offer an array of different services, levels of use, and conveniences. Each site should be visited in order to see exactly what is offered and whether it will work for you.
This is a multiresource site that offers an easy-to-use dictionary, articles and tutorials, professional exam preparation, reports, quotes, and financial calculators—as well as free paper trading.
From the home page, go to the link for “stock simulator” and enter the “Investopedia games” area. Choose the game that includes both stock and options trading. By participating in a game, you are ranked according to the profitability of stock and options trades you enter. This makes paper trading interesting, because it enables you to compete against other investors.
The stock simulator starts you out with a mock portfolio valued at $100,000. This is a nice, tidy sum to begin your portfolio. However, for most individuals, starting out with such a large amount of capital is not realistic. One frustrating aspect of getting into options trading is that for most people, the limitations of capital prevent extensive trading activity. So in that respect, paper trading with a $100,000 portfolio does not approximate a real-world environment for the majority of people.
The system also requires a form of diversification. No one position can exceed 50 percent of your total portfolio value, so that you have to put the cash to work in two or more different stocks and/or option positions.
The Chicago Board Options Exchange (CBOE) is the site where options are traded and cleared. Located in Chicago, the exchange is an interesting one, and its web site offers an array of tools and features specifically aimed at options traders.
From the home page, link to “trading tools” and then to “virtual trading tool.” One of the most interesting features of the free CBOE paper-trading page is that it asks you to set up your own trading level. It sets this based on your experience, interests, and skill levels. So as long as you set up the account to honestly reflect your personal experience and knowledge, the site will impose the same restrictions on you as those of a real brokerage firm.
You can also set up the dollar amount of your portfolio from $5,000 and up. You should establish your account to start out at the level you are likely to start in a real trading account, so that your paper-trading experience will take place in an environment similar to the one you’ll experience later on, using actual cash.
The CBOE also offers extensive and easy-to-use options quotes. If you do not yet have a brokerage account, this feature is very valuable. Many financial web sites offering free quotes are limited to stocks and are not set up for ease of use in options trading. The CBOE is an exception. Its options listings are accessible by linking to “quotes” and then to “delayed option chains.” The delayed chain link is practical for most people. It lists all calls and puts on a specified stock on a single page. This feature is valuable because you don’t need to know the symbol for an option in advance, a problem many options traders have to struggle with. Quote symbols used to be simple, but after the introduction of long-term equity anticipation security (LEAPS) options, they became quite complex. So the CBOE system is just as convenient as most brokerage listing systems.
Proceeding with a Paper-Trading Plan
To get started in paper trading for options, you may want to take three steps at the same time:
1. Open a brokerage account or continue with the account you already have. If you have an existing brokerage account where you trade stocks, continue that activity while you follow the next two steps. If you have not yet begun to trade on any level, open a free brokerage account after researching the terms and trading costs of several brokerage firms.
2. Complete an options-trading application with your brokerage firm. Download or request an options-trading application. This form asks you to specify the number of trades you execute per year and your level of experience in options trading. If you are a novice, you will be assigned a low level and probably be allowed only to open long call or put positions, at least as a start. But once you have gained some experience, you can apply to be upgraded to the next level.
3. Find a paper-trading site that fits your needs and begin actively trading options. Check out several paper-trading sites and find one that is flexible enough for the kind of trading you want to try. Also, make sure it works. You can open a free account on several sites and navigate your way through the paper-trading feature before deciding whether to remain with a site or not. Try to think of your paper trades as real; avoid the problem of not taking the paper-trading activity seriously. Begin with a specific portfolio amount and see what kind of net returns you realize through paper trading. That is the only way to ensure that once you begin putting actual money into trades, you will know what to expect.
The next chapter expands the whole question of strategies, risk levels, and the use of options. By applying options as a tool in specialized trading strategies, you achieve many benefits: You can expand your trading with options because they cost a fraction of stocks, limit your overall risks, and use puts for short-side positions without having to go short.
