Paper Trading: Pros and Cons

A traditional answer to the limitations of system design is to use a trial period during which you trade the system "on paper." Paper trading will certainly help you address and understand the mechanics of actual trad­ing. You can practice all the steps of implementing the system, such as creating portfolios, generating orders, tracking fills, monitoring risk, and scoring profits and losses. In addition, you can keep a diary of your emo­tions, which is very useful to track your trading beliefs and patterns.

Do You Believe in Your System? 243

Another valuable way to use paper trading is to analyze your system results trade by trade. You should try to relive the trades, scanning through the chart one day at a time, writing your reactions to chart pat­terns, equity levels, volatility, and so forth. Even though this is not a per­fect solution, reviewing historical trades in detail will give you valuable insight into system performance. The extra insight will enable you to deal with the ups and downs of the system in actual trading.

However, paper trading does not tell you much about actual system performance. Thus, you will gain little additional insight into system performance that you have not already gleaned from system testing. Let us assume that during testing your system produced eight successive los­ing trades. If the system produces three successive winning trades during paper trading, this does not mean it is a great system. Similarly, if it gen­erates ten successive losing trades, it does not mean it is a useless system. Precisely because successive trades are unrelated, you cannot use the re­sults observed in paper trading to make sweeping generalizations about overall system performance.

Another disadvantage of paper trading is that it still lacks the fear of losing that afflicts trading with real dollars. Thus, paper trading can still insulate you from the emotional demands of real trading. In spite of these limitations, paper trading offers a reasonable means to close the gap between system design and implementation.