Making the Transition from Investor to Trader

Paper trading is fun but it won't teach you how to take money from the markets. The problem is that fake positions don't trigger the raw emotions that force most traders to make critical errors. It's more effective to trade very small positions, with real cash on the line, because it teaches everything you need to know price movement, with little risk.

Small trading forces you through the same hoops as the big boys, with a thousand decisions about choice, entry, management and exit. This exposes your weaknesses in a safe environment so you can make incremental adjustments while you learn. In a nutshell, you're modeling the activities of the professional you hope to become one day.

It works like this. Take as many small positions as possible and follow each one to its rational conclusion. Make sure to keep accurate trading records and a detailed diary. Jot down the justification and thought processes at work for each new entry and exit. Be honest and document your emotional state while the position was in play (see "What Traders Can Learn From the New England Patriots").

Go ahead and do all the things that would cause sleepless nights if more money were on the line. These include gunslinger activities like buying/selling into earnings reports, playing gaps, shorting rallies and catching falling knives. It's amazing how easy it is to overcome your fear of the unknown through real life experience.

This modeling process has an additional benefit -- it builds valuable statistics on winning and losing percentages. This is a great way to visualize your future performance in real-world trading conditions. It's also a better learning tool than paper trading because your gains and losses are real, and not imagined.

Sadly, most newbies aren't willing to model their strategies because they're caught up in the maelstrom of greed and fear. Inevitably, this reactionary approach hurls them into a meat grinder that few will ultimately survive. Alternatively, taking the time to learn the game in a controlled environment builds the necessary skills to make money in the real world.

This column was originally published on RealMoney. For more information about subscribing to RealMoney, please click here.

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