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 mark down their hypothetical stock purchases and sales – and track their returns and losses – on paper. But today, investors typically use digital platforms to virtually test out hypothetical investment portfolios, day-trading tactics, and broader investing strategies.
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 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.
Paper Trading in the Digital Age
Some investors swear by a tangible notebook-and-paper approach to paper trading, others keep a spreadsheet, which allows them to track other factors involved in the investment, including the exact time of the purchase and sale, volume, holding period, index direction, overall market volatility, and other factors they may be studying.
But while paper or spreadsheets are valuable tools, most investors testing out their trading chops or portfolio-construction skills now prefer virtual trading platforms, which pit a hypothetical portfolio or strategy against real markets. These platforms mimic the look and feel of an actual trading platform, but deal only in hypothetical assets. Understanding a platform can make it easier to transition to real-life trading in the future.
On these platforms, an investor will start with fake money and start trading. As they do, they can track the fluctuations in an account’s value, along with profit and loss, and other key metrics, Many trading simulators offered by online brokerages allow investors to virtually trade in real-time during live markets without risking their money. For would-be daytraders, this can be a valuable experience before they dive in with real money–and the potential for real losses.
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The Pros of Paper Trading
Paper trading is a great way to learn and build trading skills in either a bear or a bull market. For new traders, a virtual trading platform offers a risk-free way to make rookie mistakes. It’s a way 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.
Paper trading allows for experimentation. For example, many investors see the value of shorting a stock now and then. But they may not know how it actually works, and what it actually pays out. Paper trading permits investors to learn how these trades work in practical terms, in order to fill out their pages. Or, they might try out other strategies, such as swing trading or options trading.
Paper trading is also 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. Paper trading is a great way for investors to learn their own tendencies and weaknesses without paying for the lesson.
Finally, paper trading can teach investors to keep their emotions in check while the markets are going up and down. Investing with hypothetical dollars can be good practice in the valuable art of making rational decisions in stressful situations and allow investors to find risk management techniques that work best for them.
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The Cons of Paper Trading
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 occasions that might require an investor to withdraw money from the market for personal reasons or the impact of an unexpected recession.
Paper trading does limits the impact of emotions, but once an investor’s real, actual money is in play, it may be more difficult to reign in emotions. That money represents a month’s salary, or a semester’s tuition, or a house payment, and so forth, so it can be hard to remain calm and keep perspective when the market plunges over the course of a trading day.
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, 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. Those brokerage fees range from $10 to $150 per trade, depending on whether an investor Paper traders may also be surprised by market realities such as routing issues, which can slow down orders, and keep them from getting the price they wanted on their trades.
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The Takeaway
Paper trading can be a great way to learn about investing. By keeping track of all trades, and the losses or gains they generate, it creates a safe, low-stress practice for examining why certain stocks, and certain trades, perform the way they do. That can be invaluable when there’s real money on the line.
When you’re ready to take the lessons you’ve learned from paper trading to the real world, you can get started by opening an account with SoFi Invest® brokerage platform. SoFi Invest offers an active investing solution that allows you to choose your stocks and ETFs without paying SoFi commissions. SoFi Invest also offers an automated investing solution that invests your money for you based on your goals and risk, without charging a SoFi management fee.
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