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The Wisdom of Paper Trading

 August 09, 2007 12:13 AM

 You've been to the library and various bookstores, maybe you've even subscribed to a trading course or two, and you've been watching markets on your own for a while. You feel confident. You feel ready. You feel lucky. Time to start trading, right?

Despite these seemingly auspicious beginnings, most first-time traders who trade without broker assistance lose money and do so fairly quickly - usually within six months. Some were unprepared for the volatility that can appear from nowhere. A tell-tale sign of this is failing to retain sufficient cash in the account as excess margin. Some fail to invest wisely, such as spending all of their cash to purchase a large number of cheap options. Some weren't as knowledgeable as they thought they were. Costs can be significant, for example, if a deliverable contract is held into the notice period.

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Others made classical errors with order usage. An example of this is using a limit order when a stop order would have been appropriate. Still others lose their objectivity at the most regrettable times. Examples of this include moving a stop order to allow for larger loss, or adding to a losing position. And, of course, contributing to the financial demise is the mystery of why prices often move in the opposite direction of what was expected.

Unfortunately, by the time the trader has begun to develop some kind of defense to the pitfalls and problems described above, usually in the form of hard-earned trading rules, the cash in the account is too low to continue. What is needed is a training ground on which mistakes can be made and lessons can be learned without wiping out trading capital. Such an educational tool exists and is called paper trading.

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Paper trading is fictitious trading meaning that buy and sell transactions are not carried through to completion in the trading pit. The trader does not have the market exposure of an actual position and so, does not have the associated risk. However, trades are filled and recorded as if they were for real. In order to be beneficial, a paper trading account should have the following:

1. Legitimacy. Third-party involvement is important. When people paper trade on their own, it's too tempting and too easy to look back at a chart and say, "Oh yes. I would have bought there." Paper trading without third-party legitimacy has little value.

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