To Paper Trade or Not To Paper Trade...

Michael and Dave discuss the advantages and disadvantages to paper trading a strategy before trading it live.

Creators & Guests

Host

Dave Mabe

Host

Michael Nauss

What is Line Your Own Pockets?

A weekly show for systematic traders who want to make more money from their trading strategies.

Michael: 00:00

Alright, everyone. Welcome back to Line Your Own Pockets. Today, we're gonna talk about paper trading. To paper trade, not to paper trade, advantages, disadvantages, how to do it, all that kind of stuff. So let's just jump right into it.

Michael: 00:15

How are you doing today, Dave?

Dave: 00:17

Good, Michael. I think it's a good topic because it's kinda surprising how strong the feelings are that people have about whether to paper trade or not to paper trade. I hear a lot of people that say they have to have a little bit of money on the line for it to matter to them.

Michael: 00:35

Mhmm.

Dave: 00:35

And my feelings have gone back and forth of the years. But I think in general, I highly recommend. And I still do it myself, but the whole point is for a trader to not jump in with 2 feet. So whether that's paper trading or trading small, I think it's really important to test the waters before jumping in with both feet. So that's the whole point here.

Michael: 01:16

So, yeah, I don't think we're gonna have a lot of disagreement on whether or not to paper trade. And I actually have an example of, something that we'll talk about that experiment that I'm doing, dipping my toes back into day trading that, more paper trading would have kinda helped me with. But I'm more interested to hear initially why your opinion had flip flopped so much. You know? I I understand.

Michael: 01:39

I definitely hear a lot of the same pushback that you have as well where I'm like, okay. You have a strategy. You tested it. Now you should go paper trade it. And the pushback always is, a, it's it's boring.

Michael: 01:52

And, you know, you're you're doing something, especially if you're very discretionary and you're you're you have to commit your entire day to watching something that you know has absolutely no chance to benefit you. And then that other one that you already mentioned is super common where it's like, oh, if I don't have any money on the line, it's going to be easier. Right? We always say that, you know, you can make a lot more money in SIM than you can in real life because you don't have that emotional emotional play. But, my argument is always for us, kinda, systematic traders, shouldn't matter.

Michael: 02:20

Right? Like, we talked about with all the advanced order types, you kinda set everything out that you want to occur, and then you you let that occur. So why has your opinion flip flops so much over the years when it comes to this?

Dave: 02:33

I think my first time that I started trading a strategy with small size. And then looking at that over time, over a bunch of strategies doing that with, I just noticed that, yeah, maybe they hadn't lost a lot of money at the beginning, but but it adds up over time. And those lessons that you learn when you first put money at risk, a lot of those you can learn by paper trading for free. So it's like skipping the tuition part or getting tuition for free, learning all the lessons you need to learn without putting actual money at risk. So, you know, even when I was trading with, you know, trading with a really small size when I was just wanting to test the waters with a strategy, Even then, it adds up over time in a way that's unnecessary.

Dave: 03:30

So I just thought it was pretty inefficient to do it that way.

Michael: 03:37

Yeah. And I'm gonna agree there. And I also always talk about this how strategies kind of degrade as you go from back test to paper trade into the live environment, and you need to make sure that those things, that you're tracking those things. Right? In in a back test, in a perfect world, you're getting perfect fills and there's no human errors, there's no power outages, there's no right?

Michael: 04:00

There there's absolutely nothing that can go wrong, and then you go to the paper trading environment and your results, you want to test to make sure that they are similar. There may be, again, some degradation, but if it goes from a profitable strategy and back test to, you know, completely blowing up in paper, then you know something's gone wrong. And like you mentioned, I'd rather learn that there. You know, maybe the speed of my strategy was too much. Maybe the fills of the back test were showing me were gonna happen.

Michael: 04:28

I couldn't get because spreads were too wide or or something like that. And we'll talk about, you know, what you should look for in a back test, right, in a minute. I think that'd be a good conversation to make sure that you're you're doing this properly. And then also, kind of like we mentioned is that, if you're going to go from that that live environment, you want to make sure that if you mess up something that you mess it up in the in the paper environment, and that's something that I'll just go through my story now where I'm taking a prop firm day trading challenge. I'm primarily mostly a swing trader and an investor, and I'll be that way always.

Michael: 05:05

But I've been working on some strategies for some time, and I've been working, to deploy those. And what had happened was I didn't calculate the, maximum the drawdown was done a little differently. So drawdown on my back sister was done on closed trades and then drawdown based off of this prop firm, which has a daily stop out limit is obviously on open trades. And I completely forgot about that, which seems like, you know, something that duh, right, someone should figure out. So when I went to the live environment, I found out that I was stopped out a couple days in a row, but yet my paper trader stayed open, and maybe at the end of the day, those positions were under that loss limit or profitable.

Michael: 05:49

So these these are things that, yes, looking back at it, I'm like, that should be obvious. I should have figured that out already. But if I had just watched the back to or the paper trader a little bit more, then that may have been something that I would have seen and said, yes. Although, I'm looking at the end of the day and these are profitable. At some point throughout the day, the system would have auto liquidated me, and that would have been the P and L that I got.

Michael: 06:13

So those differences, I think, can certainly add up, and that's kind of why I really think you should watch these whole way through because, again, depending on how you're back testing, it could be this closing data problem or any number. I think this is just a symptom of any number of little tiny problems that could come up.

Dave: 06:32

Yeah. Yeah. There's, that's a great example of, like you said, there's there's dozens, more than dozens of things that can come up that you don't even really think about until you trade something real time even in paper trade mode. I see a lot of data nerds, people who are really good at machine learning, really good with statistics. They live in the world of backtesting, and it's a completely different environment.

Dave: 07:06

Actually, go to to grade that or even follow that in real time. Like, it's a it's it's like going from something that's completely static to something that's fully dynamic. So, yeah, there's lots of lessons to learn when you do that. And you'd and then even when you paper trade, the next step of actually making some small trades in in the live market, there's a whole another set of things that you'll learn by doing that, and there's they're separate. Well, I think

Michael: 07:39

a lot of that comes to Phil's. So this is where, you know, I think if people you know, we are encouraging people to paper trade their systems before they take them live. I think, some things that are important in a paper trader that people should really look out for in all of the sum, and if I miss any, definitely let me know is is 1, it's always gonna be you want the paper trader to give you reasonable fills. And, I would look into each paper trader and say, okay. Where do you fill me?

Michael: 08:09

If you fill me at the last price, that's good. I think, bitter ask is probably better. But if you fill me at the last price, that's good, but then also the speed of it, and this is kind of counterintuitive. If I'm working with a paper trader and my fills are absolutely instant, I get more worried than if I put out an order and it takes a second or so to fill because I've noticed, there are some back testers and, you know, shout out to trade ideas here that has that ability where there seems to be a slight lag between hitting the order and getting the fill. And a lot of people would look at that as a bug, and I look at it as a feature because I'm trying to actually have, I I'm trying to, you know, work out with a weighted vest on.

Michael: 08:51

I want things to make it to be as hard as I can then so that when I go live, there's not that big degradation because, really, the the I would imagine there's gonna be more, but the big thing that you wanna look at is is how realistic are the fills in the back tester versus the live environment. I've got a funny story for this too where, there was when I was working at the prop firm, they had a simulator, but the simulator there, if you put in a stop loss, it could fill you at any price. And the rule was in the prop firm way back in the day that you had to make a certain amount of money in the simulator before you go to a live account. And, you know, they end up having to fire 1 guy because as soon as he found this out, he just spent the whole day making it. By the end of the day, he had, like, a, you know, some kinda quadrillion dollar profit that he made, and it broke the system.

Michael: 09:37

And the the, you know, the owner of the firm just took him in the back office and said, right, you're not serious. Get out of here. But, you know, that's an extreme example. I don't think there's many like that anymore, but you wanna make sure that what you're looking at is is at least reasonable to the real market.

Dave: 09:53

Yeah. I never thought about the delay of a paper trader to be an advantage. That's interesting. I've never never thought about that. Yeah.

Dave: 10:03

I created the trade ideas paper traders. So Yep. I'll take that as a compliment that the the lag that's in there is an advantage. I like that.

Michael: 10:15

Well yeah. Because I'm I'm looking at at what's happening in the real world. Right? The in now in the real world, I'll get filled quicker, but I don't want I don't want my simulated world to be a perfect world. And I think I, you know, I think my weighted vest example is a good one.

Michael: 10:31

And, you know, I used to swim competitively for the longest time, and we would do things where, in practice, we would weigh ourselves down. Right? You'd wear full clothing. You would do things to make things harder so that come race day, when you took those off, things felt way easier. And and I think you should it's better to be weighed down when you're in paper trading.

Michael: 10:52

If it's still profitable, know that you could actually get a bump when you go to the real world as opposed to the other way around. If if paper trading is too easy, then you get to the real world to get slapped in the face. That's certainly not a lot of fun.

Dave: 11:05

Yeah. I like your weighted vest example. I've used a weighted vest. There was at one point, I was trying to do as many pull ups as I could do, trying to max out on those. I was trying to do 50.

Michael: 11:15

Jeez. And At once?

Dave: 11:19

Yeah. I didn't quite get that high, but I got to 38. But a but a big reason why I got that high was I used a weighted vest, like, twice a week when I you know? So I gosh. I I really like that.

Dave: 11:35

I don't think if there's any other analogies for trading and the paper I mean, the the weighted vest. I like that.

Michael: 11:42

Yeah. I think the and the environment is is gonna be everything. Right? If you again, the I've seen videos online. I've talked to people where, you know, they're they're showing me things that would have occurred.

Michael: 11:55

And then even things like drawdown, like, they're seeing a drawdown and back test, and they're saying, oh, yeah. That was a, you know, 35% drawdown. That's fine. It's like, yeah. But feel that, you know, in the moment, I think, is is way way different.

Michael: 12:09

And even, you know, if we're talking intraday trading, again, I my example of I was looking at it and saying, oh, you know, some days I'll lose maybe $1,000 here or there. Scaled at at the size of this, obviously, I can I can scale it either way? But never thinking about, you know, what actually happens intraday that ends up ends up coming back, and these things that, again, you just won't know until you're actually paper trading. Unless you're back test or you print off a report and it had all of that that data set in it. But, again, just something I didn't think about until I went live.

Michael: 12:44

And yeah. So if I had spent a little bit more time in the paper trader, then it would make sense. And, you know, can you stomach, like, I'm looking, you know, at the back test and it's down 5, 6 days in a row. Well, a, can I stomach that? And, b, will this prop firm kick me out if that occurs?

Michael: 13:00

And that's gonna change position sizing as well. Right? I'm gonna have to make sure that, whatever the max drawdown is, that I'm I'm well under that limit for for for taking this challenge. So, yeah, just so much you can learn if you just kinda take the time to to do some paper trading.

Dave: 13:17

Yeah. There's another factor here that I thought about just as you were talking. I think at some point, I I recognized that I was too comfortable with draw downs. I I kind of thought I remember thinking that, like, kind of wearing them as a badge of honor. K.

Dave: 13:43

I'll get this big draw down, and I but I can stomach it.

Michael: 13:45

Mhmm.

Dave: 13:46

And I thought that that's not really the way I should be. Like, I should be, I should never be really comfortable with the drawdown. I should be always more vigilant than I was. And I remember thinking that with, you know, not paper trading, like trading live and suffering some small losses. I thought it was related to this, that that concept I saw in myself.

Dave: 14:17

And that that's when I started realizing that I could learn a lot more or I could learn just as much, almost as much by just paper trading without paying any of that tuition, like, that I was needlessly paying over time.

Michael: 14:35

Yeah. That that becomes a a big difference between, I think, real world and fake world. There's, it's very easy to just look at a back test and and look at a 20, 30, 40 percent drawdown, especially when you're in my world of swing trading and you're zoomed out for, you know, a very long period of time. You're you're doing a back test over 40 years, and you see, you know, there's a 2 year drawdown period, and you're down 30, 40% in that period of time. But to actually live through that, right, it it becomes very hard to you have to sit and imagine.

Michael: 15:13

Okay. Am I okay with 24 months of, you know, continuously getting hammered, until things recover? And in I'm sure in future episodes, we'll talk about ways to to mitigate that and and ways to, you know, diversify strategies away from that and that type of thing. But, it did come become it became almost like playing. It's like, oh, yeah.

Michael: 15:37

But, you know, I make this massive percentage gain over these 20 years. I would just have to, for, you know, 2,007 to 2,009, just sit there. And even when I put in things like regime filters that would just keep me out of that market for a period of time, I'm like, well, that could I really just not put on a trade for 2 years? Like, I don't you know, then what do I do? Yeah.

Michael: 15:59

Right? So it, it's there's gonna be another step too when you get to the real world that I think there's gonna be a whole other bunch of things that we can talk about that are are different from this, but it's it's how close can you kinda get to the sun before, you know, things get dangerous. Right? And I think paper trading is a good way to do that.

Dave: 16:19

Yeah. I mean, the the big reason why when I look at backtest, I look at the equity curve. When you look at just the numbers, you don't see those draw downs that or you don't you you can't feel them. And when I look at an equity curve, I know that those dips are what is gonna be the are gonna be the painful parts when I trade the strategy. Those are gonna be the difficult parts to get through.

Dave: 16:44

And that's what I'm looking at. I've just, you know, I've just been through it so many times that, and that's where people give up. That's where you give up on the strategy. So that's where you really need to focus and figure out, okay. Is this something I can live with?

Dave: 17:01

What can I do to minimize this drawdown? What can I do to or is this something I can live with? And and knowing that it's in real life, it's gonna be harder than you imagine it to be.

Michael: 17:18

Yeah. Because when you're looking at it, you're not going to sleep every night with a negative you know, you you're down from equity highs and, right, having to hang out with your kids and all these type of when when you're in it Yeah. It's it's it's party. So that's why I'm so excited about this because, you know, just talking about this, and we got a little bit ahead of ourselves there. I'm excited to chat with you about your process there and and how you're going to, get around it and and things that you're going to do because it might be different from what I do, and there may be, you know, some ideas that are are created throughout.

Michael: 17:53

So, but just to bring it back to the topic, do we have anything else to talk about on the paper trading world other than gotta find a good one and go do it?

Dave: 18:02

Yeah. I think there's a a related topic that's, what I like to call pilot trades. So so I've done some woodworking in the past, and there's this concept of a pilot hole where if you're if you're if you're getting ready to drive a nail through a board, it's a lot easier to drill a pilot hole first. So it's a smaller hole

Michael: 18:27

Mhmm.

Dave: 18:27

That guides the nail. If you're working with hardwood, Sometimes you literally can't drive a nail through it without doing a pilot. So I like to call these pilot trades where it's a really, really small amount of money that, you know, even if you had 20 trades that we're losing right in a row, it wouldn't you wouldn't bat an eye. It wouldn't really mean anything at all to you. That you know, going from paper trading to that is really valuable.

Dave: 18:57

I like to call it, you know, when you when you take that step, you're I like to call it you're getting feedback from the best traders in the world because that's really what's happening. When you It's good. Trade when you first trade a strategy, you will get feedback very quickly from the market. And, you know, I was thinking there's probably no other field where you can get that instant feedback so quickly. It's pretty amazing.

Michael: 19:27

Well and I love that. And that's something that also, you know, we, we are uniquely able to do now that we couldn't do in the past. Like, back in the day, commission costs alone were insane. Right? They're just through the roof.

Michael: 19:44

Wild. But now when you can pay 0 commissions or really, really close, you know, I know Interactive Brokers has, like, a minimum, but it's it's near nothing anyway. You can do stuff like that where you could take one share if you want it. Right? Just go in and take one share of of everything in your system and just watch how the fills are and how things work and all of that.

Michael: 20:07

I totally agree with that. But back in the day when people were paying a $100, you know, 50, $100, I heard a lot of stories of for a trade. That kind of pilot testing, wasn't able to be done. So, yeah, I think that's the next logical step. As first, you're getting a paper trader where pretty much nothing's on the line except the cost of the paper trader.

Michael: 20:28

And then you're going you're just putting a little bit on the line. You're making sure things kinda line up. And then I, you know, I always use the example of you can tell I'm a very example minded person because just how my brain works. The whole boiling the frog alive by turning the temperature up slowly. When people come to me and they say, oh, I trade really well when I'm only risking, when when or I'm putting in $1,000 per position, but I wanna get to the point where I'm putting in $10,000 per position.

Michael: 20:55

That, you know, that's a problem. And I say, well, go from a 1000 to 2,000 and then go from 2,000 to 3. Right? Go and if doing it slower makes sense. And I I think the same thing with with this scenario where there's a lot of people who are anti systematic trading because they're they don't trust the system to kinda handle these things for them.

Michael: 21:17

That's always what I say. It's like, hey. Start with 1 chair. Do that for a couple weeks outside of what you normally do, and then, you know, slowly crank that up in a way that it doesn't bother you. And then, hopefully, over weeks months, then you're kinda acclimated, and you're you're trading just like as like you would, right, with that 10,000 share investment kind of thing.

Dave: 21:37

Yep. Yeah. So I think the takeaway here is, I understand the the feeling that you need to have something at risk for it to matter, But resist that urge and realize that the whole point of paper trading is to learn more about your system, to understand more about how it is gonna work. And there's, there there's a lot of value and a lot of learning you can do just by paper trail.

Michael: 22:08

Awesome. Well, listen. Thanks everyone for joining us. I, from some of the conversations we alluded to that I had to kinda pull back on topic from, I I'm excited for where this is gonna go because, you know, 2 nerds talking about this kind of stuff seems rare out there. So, I'm excited to that.

Michael: 22:25

So any closing thoughts for the people?

Dave: 22:29

Don't think so. We'll see you next week.

Michael: 22:31

See you next week.