Many traders go through the process of designing a trading strategy or investor approach, and end their apprenticeship without fully testing their strategy. The key to successful trading is to continue to hone your approach until you are able to work out all of the kinks. The best was to handle this process is to paper trade the markets.
Paper trading is the concept of trading the markets without risking any capital. Many brokers and electronic markets allow you to do this and will help you keep track of your profit and loss, as well as your balances. Most of the companies call this a practice account, and offer you the opportunity to trade based on real time data.
Fortunately, you really do not need a broker or an ECN to help you paper trade. Paper trading can be accomplished by using a spreadsheet or even a piece of paper.
Design your Strategy
A solid trading strategy, whether it is systematic and back tested, or discretionary, should employ numerous tools to generate revenue. Every strategy should have a specific entry point that will be a beneficial point to enter the market.
For a trader that uses support and resistance along with trend lines to analyze a breakout, not only would he wait for a close above the trend line resistance (on this chart at 1.4023), but he could also wait for the market to pull back intra-day to the breakout point at 1.3934.
The entry point, allow a trader to determine the risk that they want to originate on this trade. The risk, is a term use to figure out how much money you are interested in potentially losing if the trade should move against you. In the trade above, a stop below trend line support below 1.3750 would be a solid place to exit the markets on a long position.
With this in mind, a trader is willing to enter the market at 1.3934 and willing to risk a loss to 1.3750, should expect a gain of 0.0184 that he is willing to lose. Of note, an entry point on the close at 1.4023 would require a large gain, since the loss between 1.4023 and 1.3750 is larger than the risk associated with an entry point at 1.3934.
To have a prudent risk reward profile, a trader wants to earn more on winning positions than he loses on unsuccessful trades. If the plan is to risk 1.84 big figures in EUR/USD, then a prudent gain would be a figure that is 1.0 to 2.0 times that losses you are willing to accept. In this case, the gain should be at least 2.76.
A paper trade would entail opening a position at 1.3934. If the market does not get to that level, then the trade is not initiated. It is important to think dynamically, but also stick to your plan. If the market never gets to that level, the market is telling you that there is enough support at that level to keep the market higher. You can monitor your trade for the following day, and potentially move your entry level higher if new support levels are created.
Once you place the trade, write the entry level down or put the entry point in a spreadsheet. If you are trading binary options, mark down the entry level, and explain how you arrived at the spot to enter the trade. Since, binary options trading has a different payoff profile the strategy is slightly different.
Binary Option Paper Trading
For either a call or put binary option , you also want to create the same entry level similar to the strategy of entering a standard financial instrument. You would enter the call binary option when the price moved down to the level that you would enter if the trade where a standard long position. If your strategy is based on a daily close, enter a daily binary option trade.
With binary options, your stop loss level can be used for your risk management process. For example, in the trade above, the potential loss is .0184, which is approximately 1.3%. If you lever your portfolio (similar to most forex and futures) your loss could be close to 26%. Assuming no leverage, you could replicate this number by risking an amount close to 1-2% of your portfolio. If you portfolio is 10,000 dollars, you could place a binary options trade that was approximately 100-200 dollars. A loss on this trade would be comparable to a loss of approximately 1-2% on a EUR/USD direction outright trade.
The key on any trade is to wait until the market moves to the level that you plan on initiating the trade. If you become anxious and enter the trade early, not only are you not sticking to your plan, but also you are likely to enter into an unsuccessful trade.
Just because a strategy works when paper trading forex or futures, it does not mean that it will convert over to a successful binary options strategy. Testing by paper trading is a way that you can ensure your strategy works in the real world, before risking capital.
Back Testing Binary Options
Binary option historical data is available through the CBOE Chicago Board of Options Exchange. This regulated product has daily settlements that are verified by the exchange. Volume levers on this product is relatively weak, the settlement value is consistent.
Paper trading is an import part of building a successful trading business. It is one of the few businesses available that you can “test the waters” prior to risking your capital. Every market offers the opportunity to forward-test a strategy that you designed or back tested. Use this opportunity to insure that you will have a success trading operation, and then move forward.