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Paper Trading

Paper trading is simply keeping track of imaginary money in real investments. The idea is to find out how you would have fared if you had really traded the stocks with real money. It helps you learn the ropes without risking a dime.

For example, you might want to start with a portfolio of $100,000 of imaginary money, and invest it into your favorite penny stocks. Over time you could trade in and out of your positions, keeping regimented notes of what you have gained and lost.

After your paper trading exercise has expired, you can look back and see how you fared, where you made the most money, and which strategies worked.

You can learn the ropes of investing, including choosing and monitoring stocks, and deciding on your entry and exit prices.
To develop an investment strategy or methodology.
To test or refine an existing investment strategy or information source.
To keep an eye on stocks that interest you, with the purpose of uncovering accumulation or sale opportunities.
For fun.
To decide upon the best sources of information, quotes, charts, news, and tracking.

There are any number of ways that you can start up and monitor your own paper trading strategy. What I describe here will simply be the approaches that have had the best results in the past and have garnered the most positive feedback.

However, before you decide on an approach you first need to decide on what your results should be from the exercise:

Are you trying to uncover stocks to invest in?
Are you testing a new investment methodology and want to see what results you can attain with it?
Do you just want to learn how to trade penny stocks?

Your answers to these questions may influence your paper trading parameters.

There are several parameters that can be customized to your own personal preferences. Each should be adjusted to be as realistic to your own personal investment situation as possible. For example, starting with $10 million in cash may yield very different results than what you eventually may get from your real $2,000 investment.

Starting Cash

Generally begin with enough cash to let you get a feel for the market, and experiment with several different stocks.

If you have $1,000 real money to eventually invest, and you know that you will be putting that into two different penny stocks, you will certainly need to be highly selective in your choice of stocks.

Therefore, you will also want to encourage a paper trading strategy that forces you to be highly selective while you are learning the ropes, so that the jump to real trading will be relatively parallel.

However, if you keep the imaginary cash level too low, you may not get involved with very many paper trading decisions. Thus, you may not learn very much from the exercise.

I feel that traders should start with between 5 and 10 times their real money level for paper trading. If you eventually will be using $3,000 to invest, an imaginary starting level of $20,000 cash would be appropriate to trade many different stocks, without becoming too unrealistic.

I also believe that, especially for penny stocks, you should have a minimum of $10,000 and a maximum of $50,000 imaginary starting cash.

Keep the amount a nice, round number so that it is easy to tell if you are up or down, and by how much.

Time Frame

Decide when the paper trading exercise will begin and end. This enables you to see how much money you could have made or lost within a set time period.

Note that paper trading exercises do not have to end at all. Instead, you can see how your stocks have fared month by month, year by year, indefinitely.

I suggest that you paper trade for many months before getting involved in the markets with your actual cash. At the same time I understand that you will be very anxious and excited to begin making these trades with real money, especially if your strategies are paying off.

Decide on These Parameters

Starting Cash
Time frame
Screening (Criteria for Stocks)
Pricing (Recording of Transaction Prices)
Trading Activity Parameters / Rules
Stock Monitoring Methods
Paper Trading Tracking Methods

Screening

You may want to limit the theater of paper trading, by only looking at certain stocks on certain markets, or only buying into shares that are below a certain price point. Alternatively, you may decide to have the pool of potential stocks literally unlimited, just as it is in real life.

I suggest that you do not use OTC issues for paper trading, because as I explain earlier, you may not be able to sell your shares when you want. Just because the quote is $1.55 does not mean that you would be able to sell your shares at that price, or at all, so it may create misleading results in your paper trading.

Screening can be done by choosing;

the price of the stocks you will be paper trading;
the market that you will focus upon;
a specific industry or sector (ie-no biotech stocks, heavy weighting of Internet issues, etc...).

It is based mainly on your own preferences and should be in line with the stocks you will eventually be trading. Of course, I also understand that you may not know what types of stocks interest you yet. Hopefully paper trading will give you a feel for many different industries, markets, and prices of stocks.

Trading Prices

Decide on your method of recording share prices for your trades. During any given trading day shares open at a certain level, move around between an upper and lower threshold for the day, and then close somewhere within that range.

If you are trading for real, you can know the price you paid for shares because it will be part of your trade receipt. You will be able to access it through your online broker, and you may have even used a limit order to set the price of the trade.

With paper trading you will not have that luxury. You need to choose the meter you will use to gauge the prices of the stocks you trade. For example, you may decide that you will use the day's closing price for each stock, whether you are buying or selling. You decide to buy 5,000 shares of TMED on Tuesday, so you take Tuesday's closing price for TMED to calculate how much the 5,000 shares cost you.

While the above example is the easiest for tracking purposes, it is the most unrealistic. If you have the time to check stock prices throughout the day, you may want to instantly check the price the shares are trading at as soon as you make your buy or sell decision.

Other markers you could use would be intraday high or low, the day's average price, or the opening price. These all sacrifice some realism for the sake of simplicity, and may cause aberrations when you apply your strategy to real money situations.

If you are thinking about using limit orders, which you should be, make a note of your buy or sell limit price upon deciding to make a trade. Then at the end of the day see if the shares hit your target price.

For example, you decide to buy 5,000 ABC at $1.15 or lower. You later check and see that the shares hit $1.10 at one point, so you record the purchase of 5,000 shares at $1.15. If the shares had never hit your limit price (say the lowest price on the day was $1.20), mark it up as an attempted purchase, and look to the following trading day, or other stocks to fill up your portfolio.

Trading Activity

Decide if you will allow trading in and out of stocks. I do not see any reason you should not be able to sell your shares, take the cash and reinvest. Just be sure to keep extensive notes, and charge a realistic broker commission for every trade.

Monitoring

Decide ahead of time how you will monitor the stocks you are following. It should be the same sources throughout the exercise, and should also be the sources you will be using once you begin trading with real money.

If your purpose for paper trading is partially to decide on which sources are best, then try them all. Just keep track of which you were using so you will be able to look back later and decide which proved most useful, and more importantly most accurate.

Tracking

To fully benefit, you will need to keep extensive notes on your paper trading exercise. Keep everything recorded, so you can look back to uncover which trading strategies worked best.

Make notes on the following criteria and instances:

Starting cash.
Starting time frame.
Ending time frame, if any.
Any screens, limiting the stocks you can include in your portfolio.
Starting value of all the major markets, including NASDAQ, NYSE, and AMEX.
All buy and sell orders that get filled, including the stock you bought, the volume, the price per share, the total cost, and your imaginary broker fees.
All buy and sell orders that do not get filled, including the stock you attempted to buy, your limit price, and the volume of shares.
During the exercise, keep track of the value of stocks and remaining cash at scheduled intervals (for example, every month on the first day).
By completing point 1 above, you will be able to easily track your results. If you started off with $10,000 and a month later have $11,245 you will know that your paper trading strategy has netted you 12.45% in only one month.

Keep notes of your portfolio value each time you calculate it, so that you can see not only how your stocks have performed since you started the exercise, but how they have performed from one check to the next.

Keep in mind that you are not only trying to compare your results against your starting value, but also against the market and the underlying sectors in general. If the stock markets have dropped 15% since you started the exercise, but your portfolio has dropped only 2%, you can know that you are out-performing the markets.

Do not forget to take off brokerage commissions for each trade. If you have a stock broker, check to see how much they would charge you for each transaction, based on the volume, price of shares, and overall cost. Remember that limit orders are usually more expensive than market orders. Make notes of the commissions you took off your portfolio, and how you calculated each. Alternatively you could use a realistic number like $15 per trade if you are not sure what your broker will charge.

Differences between paper trading and real trading

When you make the jump to trading real money, you may suddenly find that your stocks are not performing as you had anticipated. There are several reasons that may cause this situation.

Your emotions take over. While you may have been careless and aggressive with imaginary money, your decisions and thought processes will be different once you start using your hard-earned dollars. Paper traders are generally immune to greed, panic, anger, and impatience until they dive in with real money.
Market activity will be different from the time you tried out a paper trading strategy until you start trading actual stocks. While paper trading, the markets may have held up well, only to crash once you put a few dollars in. Always compare your trading results to the overall markets.
The rules will be different, especially if you used something like the daily closing price to record your transaction levels. You can not buy or sell a stock 'at the closing price,' but instead are subject to intraday volumes and activity. You may even see yourself getting partial fills, such as 1,000 of the 5,000 shares you wanted, because the volume was not great enough at your limit price.

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