by Jeff Reeves | March 18, 2012 12:04 am
If you’ve done your research and think you have a winner, good for you! But if you’re still on the fence or uncertain about the quality of your strategy, there’s a very simple and affordable way to test out your investment thesis.
That method is the age old practice of “paper trading.” Here’s how it works:
Write a fixed sum of money down on a piece of paper. I recommend starting with a round number like $50,000, even if your nest egg is significantly smaller. It makes this exercise easier.
Write down the names of the stocks you’re thinking of investing in. You can stick to one stock if you want, but the exercise is much more educational if you use multiple picks. Heck, maybe even pick a stock you expect to crash just to see the results — it’s only paper money, after all.
Write down the current stock prices next to each name. You can’t invest exactly $1,000 in the stock market any sooner than you can buy exactly $100 worth of clothes at the mall. You are buying a finite number of shares at a set price based on current market conditions.
Divide your total investing cash by the number of stocks. Again, for ease of use I recommend round numbers. For instance, five stocks if you use $50,000 — meaning you have $10,000 per investment.
Subtract $20 from that figure. Most brokerage accounts charge a nominal fee per trade — for both stock purchases and stock sales. To pay even $10 per trade (once to buy and once to sell, for $20 total) is pretty steep, but it allows you to be more realistic with your “cost basis” by baking in a worst-case scenario fee to actually buy and sell your pick.
Divide that per-investment figure by the actual share price, rounding down. Remember: You can’t buy half a stock, so no 150.32 shares allowed.
Now just track your investments by checking the stock price every day after the closing bell to see how you did!
Here’s a sample paper portfolio for you, just in case the previous write-up is confusing.
Let’s start with $50,000 and five stocks. You have $10,000 per investment, and less your $20 fee for buying and selling that’s $9,980 apiece. Here’s how the sample stocks shake out:
Remember: The share price itself isn’t as significant as the percentage gained or lost in a given day. For instance, let’s say Stock B goes up $4 to $44 per share. You now have $10,956 in this position. What if Stock D also goes up $4? Well, then you’d be at $64 or $10,624 in this position.
You actually made a smaller profit in Stock D despite the fact that the price movement was the same. That’s because you owned fewer shares based on the higher per-share price when you bought in, and because the percentage of the gain was smaller — with $4 being 10% for Stock B but only 6.6% for Stock D.
These kind of observations will be common, and very educational for you. But rather than incur the expense and the risk of trading real stocks, why not just practice investing on paper? It won’t cost you a dime — but the experience will be just as valuable as trading real equities.
The downside is that you must have the patience to watch your stocks for several months, and maybe even a full year to see whether your research yields benefits. But in the long run, you will be better served by paper trading first. This way, mistakes will only cost you your pride — not your life savings.
Online Stock Market Games Galor
Don’t want to suffer the trouble of writing down everything? Well, thankfully there is no shortage of online “stock games” to allow you to act like you’re trading in real money. Most discount brokers offer a form of paper trading once you open an account. But if you’re not ready to make that commitment yet, here are three sites to try out:
MarketWatch Virtual Stock Exchange: Visit MarketWatch.com and click the “Games” link to the right under the “My Marketwatch” heading. You’ll have to register an email address, but it’s 100% free. You can participate in games set up by other folks, or create a private game just for yourself or a few friends. There are simple games that omit sophisticated ways of investing, or more realistic trading interfaces if you choose. Just try to opt out of the email lists so you don’t get spammed with too many news reports from MarketWatch.
WallStreetSurvivor.com: Be careful with your email permissions on this one, because they will try to sell you some “premium” products. But like MarketWatch, you can filter out the spam and simply enjoy the platform at no up-front cost. The benefit from Wall Street Survivor is that tips and education are served up as you practice trading — but the downside is they also are served up with plenty of ads.
EZtradingclub.com: Though the least user-friendly of the group, the sheer simplicity of this site actually makes it attractive to some folks. There are no loud ads or confusing contests; just a simple interface to type in tickers and transactions. It can be difficult to make your way around, but for the more Internet-savvy investor, this is the least distracting of the three platforms here — even if it’s a bit more work.
Don’t like these? Then just Google “paper trading websites” or “online stock game” to find other options. There’s no shortage of free products out there.
The benefit of online stock games is that you also can test out real-life trading techniques, such as using a “stop-loss” or a “limit order.”
A “stop-loss” is a price you set on a given investment that will trigger an automatic sell. This protects you in the event of a crash, even if you are not at your computer making the trade manually.
Some traders even constantly revisit stop losses, setting what is called a “trailing stop” on positions — say, 15% or 25% below what they paid. This means that they regularly calculate what a 15% drop is and set the stop loss anew. This helps protect your profits. Think of it this way: if you set a stop loss at $25 and the stock goes to $100, you have a heck of a ride down again before your automatic sell gets triggered!
Be warned, however, that the downside to a stop-loss is that some stocks bounce back quickly. Many an investor has been “stopped out” of a stock that crashed only to see it bounce right back up the next day. Of course, if your stop-loss fires after a 15% slide and the stock continues to tumble, you’ll save a bundle. But know the risks as well as the rewards.
A “limit order” is similar to a stop-loss, but is used on the upside. Let’s say you want to buy Apple but are waiting for it to roll back a little bit. You can set a limit order that tells Wall Street what you’re willing to pay — whether it be 5 cents below the current price or $5.
You also can use limit orders on a sale. Let’s say shares are trading at $490, but $500 is your break-even price. Some traders set a limit order and refuse to sell for anything less than that.
I personally never trade stocks using “market order,” or a transaction that allows the stock market to set the price for you. In a volatile market, you might wind up grossly overpaying for a stock you want to buy or getting an unfairly low price for your sale — especially if you are trading in a small number of shares.
The risk, of course, is that if you refuse to sell at $490, the stock could backslide to $480 before it hits $500, and you missed your opportunity. Also, if you refuse to pay more than $5 for a great stock but it keeps moving up to $6 and then $7 and then $8, you missed your chance to ride the rise.
Try out these trading methods for yourself via online stock market games and see how they work. You will find your own strategies, and learn firsthand whether they are right for your personal investing style
Check out a complete list of Investing 101 articles by Jeff Reeves for more on learning how to invest and pick stocks.
Also, for just 99 cents you can download Jeff’s e-book “The Frugal Investor’s Guide to Finding Great Stocks: 11 Free Resources to Help Beginners Identify Fantastic Investments.”
You can also buy a printed copy of “The Frugal Investor’s Guide” for $15.10 via online publisher Lulu.
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