The first article I wrote on Paper Trading explained why I believe Paper Trading should be second nature to investors. I do not believe any investor should simply put capital at risk and learn through “trial and error” methods. The belief among some investors that they can only learn through “real losses” is I believe wrong.
As I explained in the first article on Paper Trading, losing capital while learning a new strategy damages a portfolio in two ways. First there is the loss of capital which must be recovered. Second is the loss of income from committing capital into learning a new strategy, which could be producing income.
Paper Trading To The Rescue
Paper trading fixes all that and offers a lot more. The principal reason I use paper trading is to study and tweak investment strategies that will result in profits. To understand how paper trading can provide big profits is to understand how to use paper trading.
My Paper Trading Goals
When paper trading a new strategy my goals are to determine:
- The suitability of the strategy for my style of investing.
- How to integrate the strategy into my existing portfolios
- Determine how profitable on average the strategy is
- Calculate the percentage of winning trades versus losing ones
- Determine if the strategy fills a “hole” in my investment trading
- Determine if the new strategy should replace an existing one
A – Suitability
I have found that it is important that new strategies meet the style of investing I am using. This is because it is impossible for an investor to be good at every investing method or style. When I am paper trading a new strategy I want to determine if the strategy fits in well with my style of investing. This is because there are specific styles that I am good at and can profitably trade. If a new strategy can increase that profit within the same style of investing, then it is worth considering. If however a new strategy is outside the realm of my expertise then often I will study it but probably discard it as I like strategies that fit well with my goals and I do not want a strategy that is going to move me outside my comfort zone.
For example, I have never been very good at trading oil, grains and other food stuffs such as sugar and corn. Since those are not my strong investment areas, a new strategy that targets those areas must:
- Be have a profit level that at least matches my other strategies.
- Be easy to implement into my portfolios
- Be simple enough to trade as well as manage
Every investor has strong and weak areas of investing. It is important to build on the strong areas to increase profits and percentages of returns and to minimize and control losses. Spending too much time trying to learn a strategy that targets areas I am weak in, is a waste of my capital and time that could be spent on strategies that provide better returns. I always encourage investors to not be afraid to discard a strategy that is outside the realm of their expertise. There are hundreds of strategies to choose from so it is always better to focus on those strategies that can provide consistent high percentage returns. I have said many times that every strategy is not for everyone.
B – Integration
Paper trading new strategies that have significant promise of consistently high returns must also be looked at for easy integration into my existing portfolio.
For example, if I have all my capital tied to trades and I decide to implement a new strategy that does not fit quite well with my portfolio, even if the returns are high, the amount of time spent managing the expanded portfolio may not warrant the higher returns. A good example are mutual funds. I have several investor friends who use strategies to buy and sell mutual funds. They have strategies that are designed for weekly trades, others for monthly and still others for half a year. But I do not trade in mutual funds, just as they do not trade in individual stocks.
Therefore if I am trying to integrate a new strategy that targets mutual funds, for example, when in fact my portfolio is designed for stocks I could be:
- hindering the overall growth of my portfolio
- Wasting hours integrating the strategy when that time could be better spent investing within my existing portfolio
- Losing out on other opportunities that my portfolio is targeted at while I attempt to integrate a new strategy that is outside the focus of my portfolio
- Reducing the return of my existing portfolio by moving capital from existing stocks into mutual funds which I do not have in my present portfolio.
You can now understand that when paper trading a new strategy, the ease with which it can be integrated into my existing portfolio must be considered.
C – Profitability
When paper trading a new strategy one of the first things I look for is how profitable the new strategy is. I have a goal already set of 12% a year. The new strategy must produce at least a 12% return annually if it is to be considered at all. If the strategy cannot on average reach that goal then no matter how elegant or simple or even fun it may be, the strategy should be dropped and not considered. Normally I can determine profitability within a month of paper trading.
D – Consistency Of Winning Trades
Many strategies that I paper trade has excellent returns. But the best test is to keep a track record of how many winning trades versus losing trades there have been. Even if the winning trades have excellent returns and the losing trades are not that large, I know that too many losing trades will mean that at some point there will be large losses on losing trades.
Therefore I would rather have 20 winning trades earnings just 2% but only a handful of small losing trades than I would like 1 or 2 winning trades of 4% but an equal number of small losing trades. This is because I know that over time I can improve the returns of strategies as I get better acquainted with them. So a strategy that might be turning in just 1 or 2 percent a trade, will eventually turn in higher percentage returns as I get more accustomed to the strategy itself. As I become more familiar with the trade I will learn to spot better opportunities which means better returns.
A strategy then that during paper trading continues to have more than 1 loss for every 5 wins is too high a risk for my portfolio and I discard that strategy. When I am paper trading I want a strategy that can provide 8 to 10 winning trades for every 1 losing trade.
This reason is because I already have strategies that provide those types of return and I would be damaging my portfolio if I decided to integrate a new strategy that did not meet the same level of winning trades as the existing strategies. Part of the reason is the compounding effect of capital. Every winning trade grows my capital monthly and compounds it monthly. I would rather have consistent winning trades that keep compounding my capital versus a strategy that provides high returns one month and then low or no returns for two or three months.
E – Filling A Portfolio “Hole”
Every portfolio has “holes” that if filled can make the portfolio stronger. On the members forum I am presently paper trading a new strategy called Trading For Pennies. The Trading For Pennies strategy has the possibility of providing significant increases in my earnings if I can get the strategy to function as well as I would like. To that end I have been paper trading it on the members section since I first introduced it a couple of weeks ago.
If it proves suitable the Trading For Pennies strategy will fill the hole left by my inability to consistently buy and sell calls on the SPY ETF. This is one such hole that my portfolio faces. Another good example of holes in a portfolio is commodities such as oil or gold and silver. Since I am terrible at trading options on oil, I instead do Put Selling on XOM stock. I am equally bad at judging precious metals but my Shark Options Trading Strategy on ABX Stock (Barrick Gold) fills that “gold hole” in my portfolio.
Therefore while I may have holes in my portfolio I can often find a winning strategy that I can use to plug that hole and make my portfolio stronger and easier to manage.
F – Replacing An Existing Strategy
Sometimes a new strategy comes along that as I paper trade it I can see the potential for it replacing an older strategy that is still being used. There can be different reasons for replacing an older strategy. These can include:
- Better consistent returns with less work
- Easier to manage strategy
- Fits better with my investing style
- Lends itself better to rescue strategies to limit losses
Paper Trading Goals Summary
You can understand from the above 6 goals that paper trading allows me to strengthen my portfolio, increase my returns and protect my capital from losses. Paper trading provides everything from determining suitability of a new strategy to integrating a new strategy into an existing portfolio. By using these 6 goals when paper trading my strategies I have over the past 3 and a half decades built a strong portfolio that can withstand bear markets and the worst kinds of financial crisis.