Table of Contents
Paper trading is simulated trading, done for practice without real money. It’s a way to test different trading strategies without the risk of losing money, before an investor starts trading with real capital.
The practice gets its name from how investors would once mark down their hypothetical stock purchases and sales and track their returns and losses, on paper. But these days, investors typically use digital platforms to virtually test out hypothetical investment portfolios, day-trading tactics, and broader investing strategies.
Key Points
• Paper trading is simulated trading done for practice without using real money, allowing investors to test strategies without financial risk.
• Paper trading helps new traders build skills and make mistakes without risking real money, in both bear and bull markets.
• To start paper trading, choose a virtual trading platform, develop a practice plan, and analyze results to refine strategies.
• Paper trading allows investors to learn about investing, track trades, and examine stock performance in a low-stress environment.
• Paper trading has limitations, including not perfectly replicating market conditions and potentially encouraging bad habits due to lack of real financial consequences.
How Does Paper Trading Work?
In its most basic form, paper trading involves selecting a stock, group of stocks, or a sector, then writing down the ticker or tickers and choosing a time to buy the stock. The paper trader then writes down the purchase price or prices.
When they sell the stock or stocks, they write down that price as well, and tally up their return. Most modern paper traders can use a simulation platform to keep track of their trades, rather than a pen and paper.
What Are the Pros of Paper Trading
Paper trading has both benefits and drawbacks. Here are some of the pros of paper trading.
Practice Trading Without Risking Real Money
Paper trading is a way to learn and build trading skills in either a bear or a bull market. For new traders, a virtual trading platform offers a way to make rookie mistakes without risking real money.
In other words, paper trading is a method to get comfortable with the process of buying and selling stocks, and making sure you don’t enter a limit order when you mean to place a market order.
Learn the Mechanics of an Investing Platform
Similarly, investors can learn the mechanics, or ins-and-outs, of particular investing platforms. That can be helpful when you want to take certain actions, perhaps within a set time frame, and know exactly what to do.
Test and Refine Your Trading Strategies
Perhaps most importantly: paper stock trading allows for experimentation. For example, an investor might hear about shorting a stock. But they may not know how the process works, and what it actually pays out. Paper trading permits investors to learn how these trades work in practical terms. Or, they might want to try out other strategies, such as swing trading.
Further, you can test your own mettle. Paper trading can serve as a way for investors to learn about their own strengths and weaknesses. Traders lose money in the markets for a number of personal reasons. Some stick to their guns too long, while others give up too soon when the market is down. Some lose money because they panic, while others lose money because they ignore clear warning signs.
What Are the Cons of Paper Trading?
There are also some drawbacks to paper trading.
It Doesn’t Simulate Real Trading Emotions
The biggest drawback of paper trading is that it’s not real. An investor can’t keep the returns they earn paper trading. And those paper returns can lead the investor to have an unrealistic sense of confidence, and a false sense of security. Paper trading also doesn’t account for real-life situations that might require an investor to withdraw money from the market for personal reasons or the impact of an unexpected recession.
As such, hypotheticals don’t necessarily spur genuine emotions. You’d likely react differently with real money on the line, in other words, than you would knowing that you’re simulating market conditions. So, paper trading may not be helpful for some investors when trying to emotionally prepare for market volatility.
It Can’t Perfectly Replicate Market Conditions
While paper trading offers important lessons, it can also mislead investors in other ways. If a paper trading strategy focuses on just a few stocks, or using one trading strategy, they can easily lose sight of how broader market conditions actually drive the performance of those stocks, including stock volatility, or their strategy, or have an inflated confidence in their ability to time the markets.
They need to realize their holdings or strategy may offer very different results in a real-world scenario.
Another danger with paper-trading is that traders may overlook the cost of slippage and commissions. These two factors are a reality of actual trading, and they erode an investor’s returns. Slippage is the difference between the price of a trade at the time the trader decides to execute it and the price they actually pay or receive for a given stock.
Especially during periods of high volatility, slippage can make a significant impact on the profitability of a trade. Any difference, up or down, counts as slippage, so slippage can be good news at times. Since brokerage commissions and other fees always come out of a trader’s bottom line, paper traders should include them in their model.
It Can Encourage Bad Habits
To a certain extent, investing with hypothetical dollars can help investors practice keeping their emotions in check while the markets are going up and down. However, once an investor’s real money is in play, it can be much more difficult to remain calm and keep perspective when stressful situations arise, such as when the market plunges over the course of a trading day.
To prepare emotionally, as well as practically, for the volatility of markets, investors can also practice risk management techniques appropriate for the strategies they’re exploringĂ„. It can also be wise for novice investors to trade in smaller amounts, at first, as they learn more about the markets and become more comfortable with the interface and tools of the brokerage they’re using.
How to Start Paper Trading in 3 Simple Steps
If you’d like to try paper trading, be sure to research your investments, just like you would if you were investing for real, and use the same amount of paper money you would use in real life. This will help mimic the actual experience.
With that in mind, here are a few steps to get started.
Step 1: Choose a Paper Trading Platform or App
If you choose to paper trade with a pencil and paper, you can simply choose a stock or group of stocks, write down the ticker, and pick a time to buy the stock. You then write down the purchase price, or prices. When you sell the stock you record that price and then figure out your return.
If you decide to use an online investing platform, you’ll need to choose a platform. There are many free platforms available. You may want to look for one that has live market feeds so that you can practice trading without delays.
Once you’ve selected a virtual trading platform, you’ll set up an account. Simply log onto the platform and follow the prompts to set up an account. Once you’ve done that, there should be a “paper trading” option you can click on.You’ll need to select a balance and then you should be able to start simulating trading.
Step 2: Develop a Practice Plan or Strategy
The entire point of paper trading is to practice and test out your strategies. So, have some in mind before you start. Find an investing calculator. Think about buy-and-hold tactics, or swing trading and daytrading techniques. Give it all some thought.
You don’t even need to worry about Securities Investor Protection Corporation protection, or SIPC protection, at first, since its paper trading is all a form of practice. That protection helps protect investors up to certain amounts if they are victims of fraud or firm failure, similar to FDIC protections. SIPC does not protect against market losses, however. Try enacting your strategies over a set period of time, and see what happens. Again, this is the time and place to make mistakes, so don’t worry too much about the outcomes.
Experiment with different types of market orders, after hours trading, the whole shebang.
Step 3: Analyze Your Results and Learn
After you’ve gotten the hang of the platform and done some practicing, take a look at what your strategy has yielded, and analyze the results. Did your trend trading technique work out as you had hoped? Did you let your emotions get the best of you during a bout of volatility?
Think about the decisions you made, and how you can use what you’ve learned to sharpen your strategy when you move to trading with actual money.
The Takeaway
Paper trading can be a way to learn about investing. By keeping track of all trades, and the losses or gains they generate, it creates a low-stress practice for examining why certain stocks, and certain trades, perform the way they do. That can be invaluable later, when there’s real money on the line.
However, remember that paper trading isn’t real. In real-life trading with an investment account, you’ll have the potential for gains, but also for losses. Make sure you are comfortable taking that risk.
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FAQ
How realistic is paper trading?
Paper trading is very realistic as paper traders are working in and with actual market conditions. The only difference should be that they’re not trading or investing real money.
Is paper trading good for beginners?
Yes, paper trading can be good for beginners as it gives them a chance to refine their strategy, learn about their risk tolerances or tendencies, and learn how to use a given platform without fear of making a costly mistake.
How long should I paper trade before using real money?
The duration you should paper trade before using real money is completely dependent upon you and your specific comfort level. Some investors may not want to paper trade at all and jump right into the mix with real money, while others will want to practice for a prolonged period of time — so, there’s no single answer.
Can you make real money with paper trading?
No, paper trading is done with virtual or fake money. As such, there isn’t really a way to generate an actual return.
What is the 90% rule in trading?
In trading, the 90% rule refers to the belief that 90% of traders will lose 90% of their capital within the first 90 days of trading. This is largely due to inexperience, unproven strategies, and their inability to handle risk.
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