A few weeks back, I kicked off the Intelligent Investor Series as part of my weekly commentaries. Th...
Why Paper Trading Will Never Be the Same as Real Trading
12/28/2009 10:53 am EST
Today, we will discuss why your results in your demo account will probably contrast sharply with the results in your live account. When most people start trading, they believe their results trading with fake money will be the same as their results trading with real money. Of course, that is almost never the case. The reason for this is that a person's emotions greatly impact their decision-making abilities when real money is on the line. We will go over why this is, and go over some tips for blurring the line between demo accounts and live accounts.
First off, I want to point out that I am not slamming demo trading. Trading a demo is how everyone should learn the basic mechanics of the trading platform. It also allows people to practice following their strategy and practice entering orders. If a trader goes in a slump, it can be effective to switch to the demo for a while. When a trader is in a slump, their brain is so focused on the money they are losing that they make mistakes left and right. Switching to demo relieves this pressure and reminds the trader that they still know how to trade well. The demo is also good for working on new strategies without risking money. However, the demo results usually do not translate to live money results.
To begin with, there is one basic reason the demo seems "easier" to trade. The reason is that you can have your fake cash refilled at any time. Therefore, what is the risk? There is no risk. If you screw up, then you can start over without any penalty. This takes a tremendous amount of pressure off of you. You could blow out five accounts and win big on one, but that doesn't mean you will ever be able to repeat that one big winning account again. This is the first aspect of the demo to realize, but there are far more important factor than this.
Let's say we have moved past the obvious reason above that the demo isn't a 100% forecaster of live results. Let's say that you have some idea what you are doing, utilize proper risk management, have a strategy that gives you an edge, and have attained consistent results on your demo. The reality is that it is much easier to follow those guidelines when there is no real money involved. A trader's emotions are much stronger when trading with real money than on the demo. If you don't believe me, I doubt you have traded real money for very long. With real money, you will be tempted to commit a number of trading sins, like moving your stop farther away from the entry, exiting a position before it hits your profit targets, entering a trade that doesn't fulfill your criteria to get "revenge" after a prior loss, etc. I could go on forever with these mistakes, and you probably have plenty of your own that you could list.
So how do you make your results with real money resemble your results on the demo account? The first is to start trading with small positions of real money. Do not jump straight into risking what you think you should normally risk. If you are trading very small positions, you will not devastate your account, but you will learn what mistakes you make when you switch to live money. Even though you may be risking small amounts of money on each trade, your brain will work very differently than when you are operating on the demo.
Once you start making mistakes with real money as described above, take notes on what happened. Write down the mistake, what your mindset was, why you did what you did, and why what you did was wrong. The next step is to write down a solution to this problem. This will allow you to add valuable "rules" to your trading plan that will help protect you from your own emotions. In my opinion, it is difficult (if not impossible) to correct these mistakes before you actually feel the pain of losing real money due to the mistake (even if it is a small amount risked on each trade).
Continue this process until you become more consistent in following your plan. Of course, you will never eliminate new mistakes entirely, but this process will help you become much more consistent in actually following your plan and not deviating from your strategy. This may be a brief explanation of how to bridge the gap between live and demo accounts, but I want to reemphasize how important it is to start by risking very small amounts of real money. Don't trade the demo forever because there is only a certain level of expertise you can gain from the demo. Trade the demo until you have a basic trading plan (with a strategy and money management) that you feel comfortable executing. At that point, trade small positions of real money and you will be able to improve your trading skills much more quickly than if you only used the demo for months and months.
By Bradley W. Gareiss of GFTForex.com
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