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How to Paper Trade: Best Idea Before Options Trading

By Edited Nov 13, 2013 0 0

Even if you already have a brokerage account on the best trading platform, if you’re not consistently making money with options trading then you need to learn how to paper trade. So many traders and investors jump right into day trading and investing in stocks, options, commodities, futures, or forex without ever practicing - without paper trading. It really doesn’t matter how much money you start with -- or that you can afford to lose -- it  has to do with developing a trading strategy  to learn how to ‘win’, how to be a better investor or trader.

Online Options Trading: What Could Be So Hard?

Options trading is an interesting facet of investing because while it’s about hedging positions (long/short), derivatives (a trading vehicle tied to an underlying security), and about leverage (one call option is equivalent to one hundred shares of stock), it can also be a standalone trading strategy. There are literally thousands of ways to make money with options, but they can wipe out your account very quickly if you don’t understand what you’re doing! As you learn about calls and puts, and the differences between your option ‘rights’ and option ‘obligations’, you’ll get a better sense of the possibilities.

In terms of the ‘leverage’ of options, imagine you wanted to participate in the growth of one of the best cloud computing stocks like Rackspace Hosting, Inc. (NYSE ticker symbol: RAX). As of this writing, RAX stock is at $52.93 (2/17/12 closing price), which would cost $5293 to own one hundred shares (100 shares). But if you believe that this stock will move significantly in the next several months you can buy one RAX Sep 2012 $50 strike call option for an asking price of $850, allowing you to control the same 100 shares of underlying stock. This $850 gives you the right to buy 100 shares of Rackspace anytime between now and September for $50 per share. The main difference here is the initial cost; the main risk is that the option expires and the stock won’t.

Options Trading to Manage Your Portfolio

In addition to pure play options trading, many traders add options capabilities to their brokerage accounts where they keep their stocks and ETFs. Options can be a great way to manage a stock portfolio - both in the sense of risk management and hedging - but also to enter positions outright (i.e., covered calls, protective puts, and selling cash secured puts).

As you become more advanced with options, and their relation to your underlying stock and ETF holdings, you might eventually decide to go deeper with your options strategies to include spreads: bull put spreads, bull call spreads, bear put spreads, and bear call spreads. There are diagonal, calendar, ratio spreads, as well as butterflies, iron condors, and others. (For the analytical types, there are also many underlying decay calculations, Greeks, and options pricing issues that can factor in as well.) But for all the complexity of options, it is possible to find a solid strategy (or two or three) and consistently trade those over and over again for profits or option income.

How to Paper Trade Options

So how do you paper trade options? Well as the name implies, you could just grab a notebook, and keep your ‘trades’ on paper in a trading log. Track your date of practice ‘purchase’, call or put option price, strike price, expiration, and price of underlying at the time of the paper ‘trade’. You could also calculate risk, break even points, costs with commissions, and more.

If pen and paper is not your style, perhaps a well-formatted Word or Pages document file, or an Excel or Numbers spreadsheet will be better for your needs. The spreadsheet idea can be helpful if you want embedded formulas to help calculate downside protection, rates or return, and more.

There are also various online trading ‘games’ that you can play online that allow you to enter trades with imaginary money and track their performance, although not all of them include options in the simulated trading. Some brokerage accounts, much like all the forex platforms, are starting to offer some kind of practice area. One good example of this is paperMoney from Think or Swim, a part of TD Ameritrade. Theirs is elaborate software with stocks, options, futures, and forex plus screening, modeling, and analysis tools, and more -- and their paper trading account gives you access to it all, but with delayed quotes.

PROs and CONs of Paper Trading

So let’s weigh out the advantages and disadvantages of paper or practice trading, as opposed to just jumping into the markets with smaller amounts of money at risk.

PROs: First, of course, is that you are not risking of real funds, so you will learn a lot but have no real losses. Do you really need to lose two hundred dollars to learn about the volatility of ETFs during earnings season?

Another great benefit of starting on paper is that you can take any idea that you read or hear about, or see on a trading forum and execute a trade. With a paper trail (or spreadsheet) you can go back later and see how those ideas worked out. The best part is that you won’t be limited by funds. If you want to trade a practice account with $100K in it -- go ahead! So when you’re brother-in-law says to buy some new Chinese solar company’s stock, you can just start a practice trade in their calls and see what happens.

You can also use this to find the strategies that you like, and that work for you. You might try a range of options strategies before you find something that works for your level of understanding, risk tolerance, and temperament. Some traders want to buy calls on beaten down stocks and scalp profits from them every day, or every week. Others might want to sell monthly credit spreads on dividend stocks for income, or perhaps set up some condors or other advanced trades.

CONs:  The main criticism of practice trading is that without real money on the line, many traders and investors say that you’re not experiencing the true emotions of greed versus fear that come with live trading. Some consider paper trading too boring or time consuming when they want to be in the market. Others are concerned with the opportunity risk of missing some huge event like the Facebook IPO or some great stock market profits by not using real money or executing real trades.

Of course, these are real concerns. Small controlled live trading does provide a level of experience necessary to be successful, so it’s the next logical step after paper trading. Since trading and investing is a viable business model (for some), it shouldn’t be looked at for entertainment or excitement. If you’re bored, perhaps your approach will be  skewed too much toward unnecessary risks. And there is always ‘opportunity risk’ when you do one thing and miss out on something else, but since most day traders blow up their accounts (read= go to $0!), then taking it slow to actually learn is probably smart. Would you ever fly the space shuttle without hundreds of hours in a NASA simulator? Same difference when real money is on the line.



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