Why is Paper Trading Important?

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Once in a while, I get questions like this from new traders as well as seasoned traders (who never really paper traded in the past). When I reply, I would almost always encourage them to paper trade but they usually disagree. Their argument is quite simple – if the objective of trading the financial market is for wealth, then surely trading a live account is the way to go because you can never make money just by paper trading.

Believe it or not, you can make more money by starting your trading career with paper trading only. Yes, I kid you not. With that, I hope I can shade some light about the importance of paper trading and I hope to influence you to do the same.

Note: With the rise of modern technology, the term Paper Trading is meant to represent any form of system testings. This includes any demo trading, back testing and forward testings that you may use. 

Technical Vs Psychology?

Here’s a simple question, when you start learning to trade, what is most important to you? Technical knowledge (either fundamental or technical analysis) or Trading Psychology?

My guess is that many would say technical knowledge. Because most new traders would assume it is. Meanwhile, a minority would think that learning the psychology is important.

If you picked either of them, you are (both) right. Why? Because both of them are important. In fact, you need both as one cannot do without the other.

However, many traders still struggle to become successful traders. I believe that’s because many fail to priorities both the areas properly. Well, if you’re not convinced, please read on.

Technical Is Important

technicalAs mentioned, if you think that learning the technical is important, you are absolutely right. Unfortunately, I find that some of you would also start trading real money immediately. Some of you seem to have this “try and see” or “let’s learn by getting our hands dirty” mentality.

Of course, ‘getting your hands dirty’ is crucial but I don’t think you need to use money to get your hands dirty when learning the technical. Agree? For those who don’t, you might even suggest that traders will not understand their emotions unless they start trading real money.

Voilà… (This is usually the part where I’m most excited.)

As a new trader, if you really want to learn and understand the technical know-how of trading, then stop worrying about how your emotions will pan out. Instead, stay focus on learning the technical until you are a master at it. Until then, put your emotions aside and the only way to do that is to use a demo account.

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You see, many new traders contradict themselves by telling the world that learning the technical is important. Yet, they would also put real money at risk to understand their own emotions. While this is not impossible, it has been shown in the past that many have failed to learn both at the same time because emotions usually override our rational mind. When that happens, many new traders struggle to tell the root of a failed trade. In other words, they cannot identify if it’s their psychology or is it their system that is working against them?

Furthermore, many would end up breaking their trading rules because the irrational mind (emotions) is acting on their behalf. But if these new traders break their trading rules all the time, they won’t have enough sample trades to determine if their system is profitable at all. Not only have they messed up their system beliefs, they have also messed up their own confidence.

Thus, traders end up going in circles.

Psychology Is Important Too

Working on Psychology is important too. However, I’ll be brutally honest here, although learning about trading psychology is more important than learning the technical, it is difficult to master your trading psychology without having sound technical knowledge.

Some of you might be scratching your heads now wondering what I’m talking about. As the owner of this trading psychology website, I truly think that trading psychology is the most important element in your trading career. However, many people cannot truly appreciate trading psychology unless they have traded the financial market in the past.

roller coaster

This is just like riding the roller coaster. When you ride the roller coaster, you feel the adrenaline, the rise, the drop, the fun and the rush of the ride. However, in order to build the ride (a.k.a. the system), lots of work has been put into the engineering design (trading plan) as well as the safety features (risk management) before the structure of the ride is even built (live trading account).

Unfortunately, many traders want to enjoy the ride before even having a fail safe design. That’s like riding the roller coaster with a few missing nut.

See the problem?

Paper Trading is the Solution

This is one of the main reasons why paper trading is important. You want to separate the Technical knowledge from the Psychology of trading. More importantly, you want to manage them independently without the influence of one over another.

On top of that, you cannot ignore the fact that trading real money is a very emotional activity. While money is a very unique asset, it is also an asset that can make or break your trading. Hence, why would you want to trade real money at the very start?

Every time I explain this to traders, they tend to ignore me because – while their instincts know that paper trading is the right thing to do – their pride, ego, stubbornness is trying to rationalise why they should continue doing what they are doing. Trust me, even I struggled to revert back to paper trading when I came to this realisation.

Hence, here are some proposals that you might find helpful:

  • Paper Trade New Systems

Whenever you learn a new trading system or want to introduce one into your portfolio, always paper trade them. Do so until you are consistently profitable (on paper).

Some of you find this challenging because you don’t pay enough attention to the trade when there’s no real money at risk. However, while many are not aware of it, this is only true if you don’t set yourself a target. For example, if you have a new system, make sure to set yourself a target (say 5% gain or 10 winning trades) before you move them to a live account. This way, there is motivation to perform and that will keep your interested.

  • Start a 2nd but Smaller Account

Instead of shrinking your trading account, why not move a portion of money to a new or sub account. Most brokers can accommodate clients having 2 or more trading accounts at the same time.

Once you’ve done so, use this account to trade systems that are only marginally profitable while you find ways to improve these systems. This is part of money management because you are now trading with reduced risk. Also, put any new systems (after having successfully paper traded them) in this account too. Do not increase the risk of any new systems until they are consistently profitable in this sub account.

Conclusion

As you can see, it’s pretty easy for new traders to get confuse between managing their trading system over managing their emotions. This is probably one of the biggest challenge that new and seasoned traders need to overcome.

In order to overcome these problems, we need to separate the two elements and manage them independently. Like it or not, by paper or demo trading, we are able to achieve that and, hence, traders who have paper traded in the past will likely to become more successful traders in the longer term.

 

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