Using A Simulated Investment Account On The Road To Wealth

 |  Includes: AAPL, CBOE, NFLX
by: SA Editor Rocco Pendola

In this article, I dig deeper into a topic I've covered before on Seeking Alpha - using a simulated investment account. I discuss some of the reasons why investors should consider using one. I also get into the logistics of simulating trading. Finding a reliable way, just from a practical standpoint, to sim trade represents a major obstacle.

As an author and reader, 33_Alpha is the type of commenter you would like to hear more from. Here's a snip of what he had to say to inspire this article:

Would you mind to share some experience on how to start a simulated trade account? Part of my plan in the future two years would be buying LEAPS and start to use covered calls in my Roth. That's why I would hope to have some hand-on practice first.

My concern is how real these simulated trades are. I wonder what your thought is and if there are any limitations you think one should know.

That's a great way to go about getting into new areas, particularly options. As my partner in lawfulness, Robert Weinstein, notes at Paid2Trade:

Army tank personnel, Navy Submariners and police all practice in a simulated environment to become good at what they do. If it makes sense for all of these risk takers, it's hard to argue it doesn't make sense for you IF you truly want to be a professional trader and not simply a thrill chaser.

I would add that simulated accounts make sense not only for would-be traders, but self-directed individual investors who want to take their investing to the next level. This holds for all types of investing, even going long straight stocks, but it's even more apropos for folks in the early stages of using options.

Plenty of confusion and mystery surrounds even the most "basic" options strategies. People want information that cuts through the complicated stuff and provides the key nuts and bolts. That's why I write the articles I write and publish the newsletter. However, at day's end, there's nothing quite like actual "hands-on" experience, real or simulated.

I use various methods of simulated trading. Unfortunately, I have yet to find a platform, outside of the ones offered by assorted brokerages after you sent up an account, that accommodates real-time trading across all forms of stock and option trades without annoying glitches.

The Chicago Board Options Exchange ((NASDAQ:CBOE)) comes close with its paperMoney and paperTrade applications, but I have found both programs to be somewhat buggy. For example, I've had difficulty importing existing positions and simply following the systems that are in place to find and execute trades. If anybody knows of solid options, for free or for a cost, to conduct sim trading with full options capabilities, please let us know. That said, you do not need a full-fledged life-like trading platform to work in a simulated account.

I often receive criticism, albeit from a small number of folks who likely have ulterior motives anyway, for doing simulated portfolios on Seeking Alpha. That backlash misses the point. Critics often deride the portfolios because things are different in "real" life with "real" money on the line. You would make different choices when using real money and react differently, as a result of emotion and such, than you do in a sim trade. That much is obvious.

Simply put, you make moves in a distinctly different atmosphere when you use a simulated account. Two things critics often overlook come to mind, though. First, it's never easy to make good trades - with stocks, options or otherwise - regardless of the trading environment. Second, and more importantly, simulated trading does not always have to be expressly about preparing yourself to be a great trader or investor. I'm splitting hairs here, but it's an important distinction to consider.

From what I understand, even veteran pilots go through simulated exercises over the course of their careers. I know that professionals ranging from firefighters to paramedics regularly train, in simulated environments, on how to respond to disasters such as earthquakes and terrorist attacks. Of course, the way these folks respond in "real-life" situations will vary, from person to person, event to event and unique circumstance to unique circumstance.

Because of the role emotions and other unknowable factors play in the transition from fake to real, I have never believed in the notion of "practice makes perfect." Even so, I agree with flight simulation, disaster training and daily baseball practice for everybody from the beginner to the seasoned professional. When you simulate - or practice - real-life situations, you're learning as much about the mechanics and processes associated with those situations as you are about how you might react when the time comes.

In my $100,000 portfolio, I purchased an Apple (NASDAQ:AAPL) January 2014 $600 call. That trade killed it, turning a nearly five-figure profit. In the same portfolio, I also put on an AAPL bear call spread, which cost me about $8,500 in phony money. Feast and famine before our eyes on the same stock, using options, over the same time frame.

If I was using real money, would I have acted differently? Darn right. In fact, I did. I actually made the $600 call trade in real life. I did not do the bear call spread. However, I learned more from the failed trade than I did the successful one.

As an aside, I would argue that I have more on the line than most folks who sim trade, considering that I make my sim trades incredibly public and highly visible, plus I look for the types of learning experiences that often only high risk and losing can bring.

But, with that set to the side, entering a bear call spread and watching it fall apart as rapidly as it did taught me several lessons. It taught me to never bet against Apple (AAPL). But, it provided a free and clear perspective on that type of trade. And, in the interest of brevity, I will just say that it taught me to never play an anticipated pullback on a stock I (or others) love with that type of trade.

This year, Netflix (NASDAQ:NFLX) could have been/be a solid bear call spread candidate. Not AAPL, not Lululemon (NASDAQ:LULU), not Chipotle (NYSE:CMG) and certainly not the NFLX of the first half of 2011. By going bullish AAPL and bearish AAPL in the same breath, but using different methods in a simulated account, I was able to understand, mechanically, how foolish of a hedge/anticipated weakness-play a bear call spread is. You use that strategy on dead, stagnating stocks, not ones flying on real or misguided momentum.

Disclosure: I am short NFLX.

Additional disclosure: Short NFLX via a long position in June $40 put options.