Getting your wings

March 31, 2009 07:00 PM

So you want to rise to the top of Futures' monthly CTA ranking? You want to rule the screens like Paul Tudor Jones or maybe stride the top step of the bond pit like the late Charlie D.? Aim high, young trader, but know that before you can fly, you must paper trade.

Paper trading is an important step for all new traders - for learning the mechanics and testing methodologies. But the simulation may not be reflective of how you will do when it counts. Paper trading is a vital tool, but it must be taken for what it is: a game, the preseason, if you will, and not the real thing.

"You must have a rudimentary understanding of the futures markets and a rudimentary understanding of the system you're trading," says Richard Dickson, technical analyst at Scott & Stringfellow Inc. in Richmond, Va.

Paper trading will give you that understanding, he says.

Barbara Richards, partner and a senior vice president at the retail broker Lind-Waldock & Co., agrees: "[P]aper trading is a good way of teaching new market participants the mechanics of trading - deciding on positions and stops, entering orders, looking at [profit and loss statements], monitoring market action and how it affects their position."

Still, paper trading results aren't golden. To maintain the sports motif, the Chicago Bears won 40% of their preseason games in 1997 - not very indicative of their 15% winning percentage through week 14 of the regular season. But one difference remains between trading and sports. In sports, seemingly mediocre teams can achieve excellence when it matters most - the wild card Florida Marlins proved that in the World Series. But if you lose the virtual house on paper, you won't win big trading for real.

Here, we outline the pluses and minuses of paper trading, and review a few products and services that presume to make your practice more perfect.

The next step
Paper trading simply is watching the markets and taking note when you would have gone long or short. You then decide when it's right to exit the trade and write down any profit or loss you would have incurred. Paper trading is the next logical step to your futures trading education after you've learned the very basics. It's supposed to help you understand how your methodologies will perform in real trading and how you can improve your application.

"Right away, you will know what you don't know," says Richard Waldron, author of Futures 101: An Introduction to Commodity Trading (Squantum Publishing, 1997).

Dickson agrees: "The earlier you start making mistakes, the sooner you start learning."

While the process is simple, some still fall short with their paper trading: They may ignore the bad trades, constantly "add" to their virtual accounts or give themselves unreasonable fills. You must be honest with yourself with your paper trading results.

"If you cannot manifest the discipline to manage a paper trading program, then you won't be able to manifest the discipline to manage a real trading program," Dickson says.

The sell side is where making your trading more realistic is the biggest chore, Dickson says. Some think it's nearly impossible.

"In paper trading everybody wins," says Chuck Bohm, manager of First American Discount Corp.'s introducing broker division. "In all my years in this business, I only remember one guy who told me he lost money paper trading." Of course, that is not the case in the real world, Bohm points out.

Most agree a critical part of practicing is your "trader's diary." This is where you write down the reasons you entered and, more important, exited trades. It is these notes you will refer back to numerous times as you alter trading methodologies or even adjust a position when you're in a real trade.

While pencil and paper will work fine for most, some portfolio programs will make your notes more accessible by allowing you to search past trades to identify which ones may offer the most insight into the current situation (see below).

But no matter how realistic paper trading is for you emotionally, you'll never know if the prices you get from the paper are realistic fill prices. With a market like the S&P 500, if you pick a wrong intraday fill price, it could impact your profit by thousands of dollars. Dickson suggests those already trading who are practicing on the side should ask their brokers for reasonable fills.

Even then, what a broker sees on his quote screen may not be accurate.

"You have to understand that with paper trading, you can call a broker or trade on your own volition, but there is no way to confirm exact entry and exit points," says Bruce Humphrey, sales manager with the brokerage Ira Epstein in Chicago.

Brokerage bash
While working with your broker to simulate more exact fills may sound like a great idea, some brokers are concerned with only commission-generating business, not helping you earn your wings. But many seasoned traders think they should help.

"The industry needs to make a conscious effort to educate its clients," Waldron says. He adds the industry's reputation suffers because beginners don't understand the basics of trading and most fail. Brokers are in a prime position to remedy that, he says.

Most large retail brokerages are coming around - especially those charging full service fees - by encouraging their clients to paper trade extensively before they open a real account.

"Every company that's in the business of risk needs to have a program to train their clients to help manage that risk," one says. And many even will provide documentation and guidance.

Retail broker Robbins Trading has a program called System Assist, a "dry run" for system traders to make sure their signals match the broker's and that the results are what would be expected, says Larry Herst, Robbins Trading senior managing director. Full service brokers also are willing to walk neophytes though the general trading process several times before real trades are made, Herst says.

At Ira Epstein, clients receive charting and analysis software with each account. Humphrey says brokers encourage clients to paper trade with the software extensively before they start buying and selling real contracts.

At least one futures brokerage takes the paper trading concept one step further. Jack Carl, the discount retail division of E.D. & F. Man International Inc., runs a program that allows clients to paper trade though actual brokers. The Jack Carl program charges no per-trade or monthly fees, but clients must open an actual account of at least $5,000 to trade for real once they feel comfortable.

Bohm, whose employer competes with Jack Carl for retail commission dollars, thinks that because users must put up $5,000 to use the Jack Carl program, it has limited reach. Bohm says a simulated brokerage is a more realistic option. Those practicing may not even have the funds to open a real account, but they may be able to afford simulated brokerage fees - about $80 to $150 per month, he says.

Faking it
Probably the highest form of paper trading is using a simulated brokerage. With these, you call in an order as if you were trading real money, and the "broker" gives you a reasonable fill. At the end of the month, you'll get a brokerage statement, just like in actual trading (see below).

Simulated brokerages have come under criticism, though. Some claim the brokers aren't trained to work with beginners because most clients are prospective commodity trading advisors who are trying to build up a marketable track record. These clients typically have traded before and understand the basics.

Bob Fitzsimmons, marketing director at the simulated brokerage Auditrack, notes, though, that of Auditrack's 1,000 or so clients, 25% to 30% are individual investors. And because Auditrack is a company that focuses on simulated trading, he says his representatives are much more capable to deal with beginning customers.

"There are psychological ramifications of trading the markets that simple paper trading does not capture," Fitzsimmons says. While he says beginners can mimic many realities of real trading with a simulated brokerage, users must take the service seriously.

"If you're not trading a simulated account as you would a real account, you really shouldn't bother trading a simulated account at all," says Fitzsimmons, whose beginning clients typically use the service between three months and one year before they trade for real or decide the futures markets are not for them.

Another big part of Auditrack's service is Auditrade, a Web-based interface through which Auditrack clients can place their orders. (Auditrack also licenses the interface to brokers who want to give this service to clients.) Fitzsimmons says that half of Auditrack's retail clients have switched over to the Auditrade service since it was offered (see below).

Auditrack is not the only choice in simulated brokerages. Hendersonville, N.C.-based TradeComp International has offered simulated services since 1992. Chris Eudy, TradeComp's owner, says that 75% to 80% of TradeComp's clients are beginning retail traders. One area the company focuses on is trading competitions. Eudy says this adds another level of competition to the service and makes it even more realistic in terms of the emotions you feel when trading.

"I have one client who says that some of his trades are 'six cigarette trades,'" Eudy says.TradeComp clients can submit trades via telephone, fax or e-mail.

Still another option is the Web-based simulated trading the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT) offer for their new, retail-sized stock index futures. Both services are very cheap - $10 for the first month with no limit on the number of trades - and both use the Auditrade interface.

Some still contend that a simulated brokerage service, whether through TradeComp, Auditrack, an exchange or a real broker, may not add much above simple paper trading.

"If you feel like you need that added crutch, fine," Dickson says. "But you're going to spend enough money on your trading education as it is without spending additional money [on] someone to hold your hand."

The simulated brokerages do concede so much: "It's not perfect," says TradeComp's Eudy. "Nothing is as perfect as trading real money. But this is as perfect as it can get. If you can't trade in a simulated market, you're not going to make it trading for real."

Trader meets world
Of course, the most exciting step in paper trading is when you stop to risk real money in real markets. So when do you make the leap? It's not just when you've made X amount of dollars or X% on your starting stake.

Dickson says it's time to trade when you're satisfied with your total results, not just your net profits. Drawdowns, pyramiding and your general market comfort count too. While the time varies for everyone, Dickson doubts anyone should paper trade for less than half a year.

Know, too, that merely good paper trading results - not the 1,000% returns many toss around the industry - shouldn't discourage you from real trading. (Remember, paper trading is not primarily for testing the statistical soundness of a methodology but rather an opportunity to practice it.) If you control your risk and feel confident, you still can succeed despite moderate, yet consistent, paper results.

"A trader...might actually be better than the paper trading results if being in a real market situation forces that trader to be more disciplined and focused," Richards says.

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