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<i>TSC</i> Options Forum: Practice Makes Better

Paper trading is a great educational tool, but there's no replacement for the real thing.

Steve, I'm recently retired and have been investing on my own for a few years. I've read your columns with great interest over the past few months and have tracked some of your suggestions on paper -- you have made some good positions -- and I now have a good understanding of how options work (I like that you emphasize hedging and limited risk and made me rethink options as a risky bet). I'm thinking of adding options and trading more actively to provide some needed income. My question is, how can I start to trade options on my own without risking too much money?-- A.G.

Given its low barrier to entry, unlimited profit potential and flexible work schedule, the prospect of deriving income from trading holds great allure for people of all ages or financial circumstances, and paper trading may be the final seduction.

Professional athletes (aren't sports always the best analogies?) can train and practice full time, but they'll often offer the excuse that they weren't "match-tough" or "game-ready" for an otherwise inexplicable loss. Similarly, paper trading is a necessary and logical step in building skills, but you should be aware of its limitations in guaranteeing real-time trading performance.

That said, technology continues to move paper trading closer to the real thing.

"The two main obstacles to trading options for the average investor have been cost and complexity," said David Kalt, president of online trading firm OptionsXpress. While even transaction costs as low as $15 won't make trading one or two contracts of a 50-cent option economically sensible, discount firms such as Kalt's have mostly eliminated that first barrier.

And Kalt believes the software applied to the recently introduced

paper-trading program on the firm's Web site provides the verisimilitude to significantly improve the education and preparation process of options trading.

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The main feature improvement to the age-old process is that "it uses real-time quotes, liquidity and volume in assessing the likelihood of order execution," said Phil Bennett, vice president of customer service at OptionsXpress. Basically, the program won't "fill" an order unless it trades at that price (this includes spreads, covered calls and other multipiece transactions).

The particulars of where, when and at what price an option order may get filled are crucial to providing an accurate real-time trading experience. "This helps people make a transition in that they become aware of simple mechanics and helps them avoid mistakes," added Bennett. Some common mistakes include assuming that closing prices or going between the bid/ask provides an accurate reflection of where a trade can be done. This assumption can be very misleading and is often the reason why paper-trading results don't match real performance.

Of course, no matter how far technology advances, paper trading will never truly replicate the trading experience. There are rows of shelves filled with books on the psychology and emotion of trading with real money. Everyone responds differently to stress and risk and reward. While OptionsXpress might put $5,000 in your paper-trading account, you'll never confuse that with money you're actually making or losing.

This isn't to say that even experienced options traders can't find benefit from the paper-trading tool. As this reader asks:

I am just trying to figure out the best overall methodology/thought process to use in selecting the "optimum" outright long call or put contract for a given trade -- and then of course trying to include in the mix those contracts with the best liquidity, narrowest bid/ask spreads. Thanks.-- T.G.H.

By entering "paper" orders you can get a sense of how liquid and fair a given options market is without risk. Getting the pulse of a given issue will allow you to determine whether its markets mesh with your investment style and expectations.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

Steve Smith.