InvestX Archives | Page 9 of 28

Sep

2023

How Dark Pools Operate – and Why They Exist

What Is a Dark Pool in Trading?

By Colin Dodds | Growing Wealth, invest, Investing, Terminology | Comments Off

Dark pools, sometimes referred to as “dark pools of liquidity,” are a type of alternative trading system used by large institutional investors to which the investing public does not have access.

Living up to their “dark” name, these pools have no public transparency by design. Institutional investors, such as mutual fund managers, pension funds, and hedge funds, use dark pool trading to buy and sell large blocks of securities without moving the larger markets until the trade is executed.

Understanding the History of Dark Pools

The history of dark pools in the trading world starts in the 1980s, following changes at the Securities and Exchange Commission (SEC) which effectively allowed brokers to make trades in large share blocks. Later, in the mid-2000s, further SEC changes that were meant to cut trading costs and increase market competition led to an increase in dark pool trading.

Dark Pool Examples

There are many dark pools out there, and they can be operated by independent companies, brokers or broker groups, or stock exchanges themselves. An internet search would bring up names of specific dark pools.

But to get a sense of how a dark pool can be used to investors’ benefit, say there’s a mutual fund looking to sell 2 million shares of Stock X. Given that selling that amount of shares would create ripples in the market, the mutual fund may not want to sell them all at once. As such, they sell them in blocks of 10,000, 1,500, or 5,000 shares — and find buyers for the smaller blocks accordingly.

This method makes it less obvious that a huge number of shares are being sold, which could avoid Stock X’s shares losing value quickly.

Who Runs Dark Pools?

Investment banks typically run dark pools, but some other institutions run them as well, including large broker-dealers, agency brokers, and even some public exchanges. Some trading platforms, where individual investors buy and sell stocks, also use dark pools to execute trades using a payment for order flow.

Recommended: What Is a Market Maker?

The role of dark pools in the market varies over time. At times, dark pool trades comprise as much as half of all trading in a single day, while at other times, they make up significantly less of U.S. equity volume.

Because trades in a dark pool aren’t reflected in the prices on a public exchange, participants in a dark pool trade based on the prices offered on a public exchange, using the midpoint of the National Best Bid and Offer (NBBO) to set prices.

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Why Institutions Use Dark Pools

Large, institutional investors such as hedge funds, may turn to dark pools to get a better price when buying or selling large blocks of a single stock. That’s because of the way that large trades impact the public markets.

As discussed, if a mutual fund manager, for example, wants to sell a million shares of a given stock because it’s underperforming or no longer fits their strategy, they’d need to use a floor trader to unload the position on a public exchange. Selling all those shares could impact the price they get, driving down the VWAP (volume weighted average price) of the total sale.

To avoid driving down the price, the manager might spread out the trade over several days. But if other traders identify the institution or the fund that’s selling they could also sell, potentially driving down the price even further.

The same risk exists when buying large blocks of a given security on a public market, as the purchase itself can attract attention and drive up the price.

New Risks

The risks of attracting attention from other traders have intensified with the rise of algorithmic trading and high-frequency trading (HFT). These strategies employ sophisticated computer programs to make big trades just ahead of other investors. HFT programs flood public exchanges with buy or sell orders to front-run giant block trades, and force the fund manager in the above example to get a worse price on their trade.

Dark Pool Benefits

Utilizing a dark pool and conducting a dark trade, institutional investors can sell a million shares of a stock without the public finding out because dark pool participants don’t disclose their trades to participants on the exchange. The details of trades within a dark pool only show up after a delay on the consolidated tape — the electronic system that collates price and volume data from major securities exchanges.

There are other advantages for an institutional trader. Because the buyers and sellers in a dark pool are other institutional traders, a fund manager looking to sell a million shares of a given stock is more likely to find buyers who are in the market for a million shares or more. On a public exchange, that million-share sale will likely need to be broken up into dozens, if not hundreds of trades.

Criticism of Dark Pools

As dark pools have grown in prominence, they’ve attracted criticism from many directions, and scrutiny from regulators. For instance, the lack of transparency in dark pools and the exclusivity of their clientele makes some investors uneasy. Some even believe that the pools give large investors an unfair advantage over smaller investors, who buy and sell almost exclusively on public exchanges.

The Takeaway

As discussed, dark pools are sometimes referred to as “dark pools of liquidity,” and are a type of alternative trading system used by large institutional investors to which the investing public does not have access. They’re typically run and utilized by large investment banks.

Given the nature of dark pools, they attracted criticism from some due to the lack of transparency, and the exclusivity of their clientele. While the typical investor may not interact with a dark pool, knowing the ins and outs may be helpful background knowledge.

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FAQ

How can you see dark pool trades?

Investors can access dark pool trading data through various securities information processors, and can be accessed through FINRA’s website as well.

Who regulates dark pools?

The Securities and Exchange Commission, or SEC, is the government body that regulates dark pools and dark pool trading.

What are dark pools in cryptocurrency?

A dark pool in cryptocurrency is more or less the same as a dark pool in other equities markets, and is a place that matches buyers and sellers for large orders outside of a public exchange or view.

How do dark pools differ from lit pools?

As many might surmise, lit pools are effectively the opposite of dark pools, in that they show trading data such as number of shares traded and bid/ask prices.

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Sep

2023

What Is Tax Lien Investing?

By Colin Dodds | Financial Independence, Growing Wealth, invest, Investing | Comments Off

Tax lien investing involves an investor buys the claim that a local government makes on a property when an owner fails to pay their property taxes. Each year, states and municipalities sell billions of dollars in tax liens to the public.

The lien itself is a legal claim of ownership that a city or county makes against any property whose owner hasn’t paid taxes. The government then sells those claims, usually at auction, to investors. It is considered an alternative investment and a way to get real estate exposure in a portfolio.

How Tax Lien Investing Works

Tax lien investing involves an investor purchasing a property at auction that currently has a tax lien against it. They pay off the lien, and then the property is theirs, typically purchased as an investment.

If an investor wins a tax lien certificate at auction, they must immediately pay the state or local government the full amount of the lien. Then entitled to collect the property’s tax debt, plus interest and penalty fees. The interest that the property owner must repay the investor varies from state to state, but is usually in the 10%-12% range, using a simple interest formula. Some states charge as much as 2% per month on tax liens.

Property Tax Liens Explained

Between 2009 and 2022, historically low interest rates led many income-oriented investors have started to look more closely into buying tax lien certificates as a way to generate more returns from their portfolios. With relatively high interest rates, tax liens offer one way to generate investment income. Unlike many other interest rates, the rates on property taxes aren’t affected by market fluctuations, or decisions by the Federal Reserve. Instead, state statutes set the interest rates on overdue taxes.

That makes tax liens a potentially attractive alternative investment in a period of rock-bottom interest rates. But they come with their own unique risks. For starters, the investor only realizes the high interest rates if the property owner agrees to pay them.

The fact that the property owner is delinquent on their taxes may indicate, however, that they’re in a bad state financially, and unable to pay back the new owner of the lien. In that case, the only way for an investor to recoup the initial cost of buying the lien, plus interest and penalty fees, is to foreclose on the property and sell it. In that situation, the investor gets the money from the proceeds from the sale.

The good news for tax lien investors is that the lien certificate they receive from the local government usually supersedes other liens on the property, including any mortgages on it. That entitles the tax-lien investors to full proceeds from a foreclosure sale in most cases. The only creditor on a property who may have priority over tax-lien investors is the federal government for liens imposed by the Internal Revenue Service.

The bad news is that the lien certificates don’t, in any circumstances, give the investor ownership of the property. In cases where the property owner doesn’t pay the investor the money owed, a tax-deed foreclosure is the only way an investor can get paid.Those proceedings, along with eviction, repairs and other costs, can cut into returns made by the investor.

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How to Buy Tax Liens

Not every state allows the public auction of overdue property taxes, but thousands of municipalities and counties across the country currently sell tax debt to the public.

For a new investor, one place to start looking into buying tax liens is by getting in touch with your local tax revenue official. They can point you to the publication of overdue taxes. Most states advertise property tax lien sales for before the actual sale. Most of the time, these advertisements let you know the property owner, the legal description of the property, and the amount of delinquent taxes.

How Do Tax Lien Sales Work?

Tax lien sales often, or mostly, happen at auction. The auctions themselves vary by municipality and state. Some are online, and others are in person. Some operate by having the investors bid on the interest rate. In this auction format, the municipality sets a maximum interest rate, and the investors then offer lower interest rates, with the lowest bidder winning the auction.

In another popular auction format, investors bid up a premium they’re willing to pay on the lien. In this format, the bidder who’s willing to pay the most — above and beyond the value of the lien — wins. But the investor can also collect interest on that premium in many cases.

If that sounds like too much work and research, investors can access this unique asset class by purchasing shares in a tax lien fund run by an institutional investor. Institutional investors may have the research, focus, and experience new investors may not have, or want to develop. Professional investors also have experience with some of the litigation and other expensive pitfalls that can come with a property foreclosure.

Tax Lien Investing Risks

As a financial asset, tax liens offer a unique opportunity for income, but they also have their own set of risks. The first is the property itself. The neighborhood and condition of the property make a difference in the value of the property and the ease with which an investor can sell it.

Another investment risk to keep in mind is that some owners may never pay back the property taxes they owe, and if the value of the property, after foreclosure, may not pay back the money invested in the lien. Investors also may have to deal with a property embroiled in litigation, or on which other creditors have a claim. This is one area where research can make a big difference.

Also, liens don’t last forever. They come with expiration dates, after which the owner can no longer foreclose on the property or collect overdue taxes and interest from the property owner. In some cases, investors will pay taxes on the property to which they own the lien for years, just to keep a claim on the underlying property. This can be a smart strategy if it gets the investor the property at a lower price, but it can also create opportunity costs.

Finally, the overall returns on tax liens are going down in many cases, as more large institutional investors start bidding on tax lien auctions. More bidders drive down the interest rates or drive up the premiums, depending on the auction format.

Benefits to Investing in Tax Liens

Investing in tax liens also has its potential benefits, including the chance of generating outsized returns (but keep the risks in mind, too). Sometimes, properties can be purchased for a relative bargain — such as a few hundred or a few thousand dollars, which can obviously be attractive to investors, though it may not be typical. Tax lien investing is another way to diversify a portfolio as well.

The Takeaway

Tax lien investing involves buying the claim that a local government makes on a property when an owner fails to pay their property taxes. Once an investor buys that claim, they then pay off the back taxes, and take ownership of the property. Each year, states and municipalities sell billions of dollars in tax liens to the public, making for ample opportunity.

Tax lien investment can offer an alternative investment that balances out a diversified portfolio, but it has many risks that individual investors should understand. Of course, there are plenty of other ways that investors can put their money to work for them.

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FAQ

How can you get started in tax lien investing?

Prospective tax lien investors can get in touch with local tax officials to learn more about tax liens in their area, or do some internet searches to find when and where auctions are taking place. They can then bid and potentially win a claim on a property.

What’s the difference between tax liens and mortgage liens?

Tax liens are placed on a property by the government for unpaid property taxes, whereas a mortgage lien is placed on a property by a lender in order to secure it for a borrower failing to pay their home loan.

Are IRS tax liens public record?

IRS tax liens are federal tax liens, and are public record. The IRS will file a public document to alert others in the even that a federal lien is being placed on your property.

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Sep

2023

The Effects of Deadweight Loss

By Matthew Zeitlin | invest, Investing, Terminology | Comments Off

Deadweight loss is the term used to describe societal or economic losses caused out of inefficiencies. It’s an economic term, and refers specifically to losses created as a result of a lack of equilibrium in supply and demand models — or, in other words, when resources are not being used as efficiently as possible.

This can have larger impacts on the overall economy, which can trickle down and have an effect on the markets and on investors, too. As such, investors would do well to understand the concept, and how it may impact their portfolios.

What Is Deadweight Loss?

As noted, deadweight loss refers to inefficiencies created by a misallocation or inefficient allocation of resources, and is an important economic concept. Deadweight loss is often due to government interventions such as price floors or ceilings, or inefficiencies within a tax system.

To understand more fully, it can be helpful to think about how government interventions can impact the equilibrium between supply and demand.

First: How to Calculate Surplus

In order to know how to calculate deadweight loss, we must first be able to calculate surplus.

Typically, a business will only sell something if they can do so at a price that’s greater than what they paid for it themselves, and a consumer will only buy something if it’s at or less than the price they want to pay for it — the same principle as generating a stock profit.

Scenario A — The Equilibrium: Let’s imagine a store selling comic books for $10 each. The store buys the comic books from the wholesaler for $5 and sells them for $10, pocketing $5 of “producer surplus.” Before the store opened, comic book readers would go over to the other town to buy comic books for $15, the price they were willing to pay, but now can buy them for $10. This $5 difference between the price they’re willing to pay is the “consumer surplus”.

In this case, let’s say the store is able to sell 1,000 comic books, that means the combined producer and consumer surplus is $10,000.

Breakdown:

• P₁ = Producer’s Cost of a Comic Book = $5

• P₂ = Producer’s Price to Sell a Comic Book = $10

• P₃ = Price A Consumer Pays = $10

• P₄ = Price A Consumer Is Willing to Pay = $15

• Units Sold = 1,000

• Producer Surplus = (P₂ – P₁) * Units Sold = ($10 – $5) * 1,000 = $5,000

• Consumer Surplus = (P₄ – P₃) * Units Sold = ($15 – $10) * 1,000 = $5,000

• Total Surplus₁ = Producer Surplus + Consumer Surplus = $5,000 + $5,000 = $10,000

Deadweight Loss Graph

Deadweight loss can be found on a supply and demand graph, or supply and demand curve. That graph generally shows the relationship between supply and demand with two lines that intersect at an equilibrium point, with a downward-sloping demand line and an upward-sloping supply line.

On such a graph, deadweight loss can be found to the left of the equilibrium point, comprising both the consumer surplus and consumer surplus.

Common Causes of Deadweight Loss

There can be several causes of deadweight loss, but some of the most common are government-mandated changes to markets. Examples include price floors, such as a minimum wage, which can create some inefficiencies in the labor market (there may be workers who would be willing to work for less than minimum wage). Price ceilings, also can create deadweight loss — an example could be rent control. Finally, taxes can create deadweight loss, too.

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How to Calculate Deadweight Loss

To properly calculate deadweight loss, you need to be able to represent the supply and demand of the goods being sold graphically in order to determine prices. According to the laws of supply and demand, the higher a price goes, the fewer of that item will get sold; and vice versa.

Example of Deadweight Loss

Scenario B — Imposed Tax: Let’s go back to our comic book example and imagine that the town’s government imposes a $2 tax on comic books.

What happens to the price of comic books and the surplus generated by the sales of comic books? If consumers had to buy comic books to live (and for some, it may feel that way) and there were no other way to buy them, then the comic book seller could simply bump up prices $2 and sell 1,000 comic books for $12 each, maintaining his $5 of producer surplus on each comic book sold with $2 going to the government and consumer surplus of $3.

In this case the combined consumer and producer surplus is lower — $5 × 1,000 + $3 × 1,000 = $8,000. So there’s a missing $2,000 of what economics call “gains from trade.” But, the government is collecting $2,000, so the money does not disappear from the economy.

The government can buy things, hire people, and literally send money to people, via economic stimulus, meaning the tax revenue does not disappear from the economy.

But, despite how fervently people want them, comic books are not a necessity in the same way food is and remember that comic book store in the neighboring town? If the demand for comic books can not literally be unchanged by its price, that means the comic book seller may think twice about passing on the tax fully on to his customers and that any price increase will result in some comic books going unsold.

If he were to increase the price to $12, thus passing on the tax to his customers, he may not be able to sell enough comic books to maintain the revenue he needs to keep his store open, so he lowers the price to $11, thus splitting the tax between himself and his buyers but still reducing the number of total comic books sold. In this case, let’s say he sells 600 comic books instead of 1,000.

The combined consumer and producer surplus is $4,800 ($4 × 600 + 600 × $4) with $1,200 of tax collected (600 × $2) meaning there’s a total of $6,000 of consumer surplus, producer surplus, and government revenue. In this case the deadweight loss is $4,000.

Breakdown:

• P₁ = Producer’s Cost of a Comic Book = $5

• P₂ = Producer’s Price to Sell a Comic Book = $9

• P₃ = Price A Consumer Pays = $11

• P₄ = Price A Consumer Is Willing to Pay = $15

• Units Sold = 600

• Tax = $2/Comic Book

• Producer Surplus = (P₂ – P₁) * Units Sold = ($9 – $5) * 600 = $2,400

• Consumer Surplus = (P₄ – P₃) * Units Sold = ($15 – $11) * 600 = $2,400

• Gains From Trade (Tax) = $2 * 600 = $1,200

• Total Surplus₂ = Producer Surplus + Consumer Surplus + Gains From Trade = $6,000

• Deadweight Loss = Total Surplus₁ – Total Surplus₂ = $10,000 – $6,000 = $4,000

The higher price, created through taxation, has impacted the equilibrium between supply and demand and created a deadweight loss — the surplus that evaporates due to fewer transactions happening between the comic book seller and the readers.

While this is a rather extreme example of what happens when taxes force up prices, it’s a good way of thinking about how deadweight losses are more than just items getting more expensive. Rather, the deadweight loss formula can illustrate the evaporation of mutually beneficial economic transactions due to different types of taxes.

Deadweight loss of taxation refers specifically to deadweight loss that occurs due to taxes, but a similar impact can occur when a government puts price floors or ceilings on items.

Why Investors Should Care About Deadweight Loss

Deadweight loss can affect investors in a number of ways, and it’s important to consider it when looking at different types of investments. One of the most debated issues in economics is the effects that the tax system has on income, investment, and economic growth in the short and long run.

Some argue that income taxes, payroll taxes (the flat taxes on wages that fund Social Security and Medicare) and capital gains taxes work like the comic book tax described above, preventing otherwise beneficial transactions from happening and reducing the economic gains available to all sides. There’s evidence on all sides of this debate, and the effects of tax rates on overall economic growth are, at best, unclear.

As an investor, deadweight loss might matter when it comes to companies or sectors impacted by specific taxes, such as sales taxes or excise taxes on alcohol or cigarettes. Deadweight loss shows how taxes on specific items can not only reduce profitability by increasing a company’s tax bill, but also affect revenue by reducing overall sales or driving down prices that businesses can charge or receive from buyers. As an investor, this knowledge and insight can be useful when allocating capital between companies, sectors, or types of assets.

The Takeaway

Deadweight loss is the result of economic inefficiencies, and it can affect an investor’s portfolio if it results in slower sales and revenues for businesses. It’s a large economic concept, and may not have a day-to-day direct impact on the stock market. But it’s still good for investors to know the basics of deadweight loss and how it applies to them.

There are myriad economic concepts investors should pay attention to, and deadweight loss is merely one of them. Studying deadweight loss and related concepts can help investors plan for the future and work toward their financial goals.

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FAQ

Why does a monopoly cause a deadweight loss?

A monopoly can cause deadweight loss because competitive markets create competition and fairer prices. A monopoly distorts prices, leading to inefficiencies.

Can deadweight loss be a negative value?

No, deadweight loss cannot be a negative value, but it can be zero. Zero deadweight loss would mean that demand is perfectly elastic or supply is perfectly inelastic.

Is deadweight loss market failure?

Deadweight loss is not a market failure, but rather, the societal costs of inefficiencies within a market. Market failures can, however, create deadweight loss.

Photo credit: iStock/akinbostanci

Sep

2023

Important Estate Planning Documents to Know

By Lauren Ward | Family Finances, Life & Career | Comments Off

For many, a strategy for estate planning is a must-have at any stage in life. This ensures that your wishes on how to handle your wealth, health, and children are carried out after your demise or a medical emergency that leaves you incapacitated.

Having the proper documents in place makes it easier, faster, and less expensive for your wishes to be executed.

Here are the most common — and important — estate planning documents to know about, create, and routinely update throughout your life.

Typical Estate Planning Documents

Last Will and Testament

The foundation of your estate planning checklist is your last will and testament. This legal document essentially lets you list your instructions on what to do with your assets after you die.

Your will also names an executor, who is the individual you choose to carry out your final wishes. It should be someone you trust who can handle major financial responsibilities, since they’ll be tasked with navigating both your family and financial institutions.

When you make a will, you’ll specify who will take possession of your assets that don’t have a beneficiary assigned. You can also outline your funeral preferences and other final wishes.

If you die without a will, the state takes over and names a representative on your behalf to handle the distribution of your property. The court could name your spouse or close family member to handle the job, or it could choose a public trustee if no one agrees to the job.

The probate process takes a long time, and your family typically won’t be able to access any of your accounts until an executor is named. That’s why it’s best to get started on your estate planning documentation as soon as possible.

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Letter of Intent

A letter of intent is another component of your estate planning checklist that allows you to leave an explanation to your loved ones. You can compose an emotional letter if you want, or stick to information that will make the transition easier for your family.

The letter of intent is a good place to list details like your bank accounts, passwords, and other important information your executor or family members may need. For instance, you may have joint accounts with your spouse. But if you’re the one who manages that money or is responsible for certain shared bills, you can explain how to handle those ongoing expenses moving forward.

Also include the physical locations of important documents and assets, like property titles, jewelry, or art.

Beneficiary and Guardianship Designations

Your will documents should include designations for account beneficiaries and, if applicable, a guardianship for any minor children.

Some financial accounts require that you list a beneficiary; others do not. A standard checking account probably doesn’t require you to list a beneficiary, but you can likely volunteer to add one.

IRAs and life insurance do require you to add a beneficiary, regardless of the size of your account or policy.

While you do need to fill out the paperwork directly with the financial institution, you can also list your beneficiaries in your will documents to make it easier for your executor to access everything. Be sure to update beneficiaries if major life events occur, like divorce, the death of a spouse, or a birth.

Speaking of babies, you also need to designate a guardian for any dependents. You’ll need to include their names and birthdates and explicitly name the person or persons you wish to be their guardian should you die. If you’re in a two-parent household, the guardianship only goes into effect if both parents die.

Each state has its own way of handling minors if you pass away without naming a guardian. The court will likely pick a close family member to serve in the role, but it’s always better to make the decision on your own — especially if you have tense family dynamics.

Advance Medical Directive

An advance medical directive is a way to clarify your health care wishes in case you become medically incapacitated.

As part of this legal document, you can first name a durable power of attorney for health care. This basically hands over decision making to the person of your choice. It’s best to have conversations before any medical issues arise so they understand how you would prefer to move forward in certain health situations.

You can also include instructions for specific treatments in your advance medical directive. In what is known as a living will, you can list your stance on individual treatments and how your health care professionals should move forward in each scenario. For instance, you may include “do not resuscitate” orders or how you’d like organ donation to be handled (if at all).

Check your state laws on how to correctly instate an advance medical directive or living will. It’s also important to provide copies to your doctor and family members so that they have your wishes on hand.

If you are about to undergo a major medical procedure, you may be prompted to fill out an advance medical directive form before it takes place.

Power of Attorney

Another type of legal document to include in your estate planning checklist is power of attorney. It’s similar to a power of attorney for health care, but with much broader impact.

It lets you choose an individual to make all types of decisions on your behalf if you become incapacitated, including financial and living decisions.

You can opt to give someone general power of attorney, and that person will simply act on your behalf moving forward. Or you can grant someone individual power of attorney, which only lets them act on your behalf during specific situations that you include in the legal document.

A power of attorney becomes dissolved in a few situations. First, it automatically goes away if you die and the other directives of your will (including the executor) go into effect. It also automatically ends if you get divorced and your spouse had power of attorney for you.

Alternatively, if the person with power of attorney dies or becomes incapacitated, then they’ll no longer be able to fulfill their duties. A court can also invalidate the power of attorney document.

Just like any other role you assign in your estate planning documents, picking the right person to have power of attorney can have a major effect on your life. It’s best to choose wisely and have open conversations about your wishes if you could no longer take care of yourself.

💡 Quick Tip: It’s recommended that you update your will every 3-5 years, and after any major life event. With online estate planning, changes can be made in just a few minutes — no attorney required.

The Takeaway

Estate planning documents dictate a person’s wishes about how to handle their wealth, health, and children upon their incapacitation or demise. Making an estate plan is a good idea as it can minimize the delays, expense, and loss of privacy of the probate process.

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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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Sep

2023

Pros and Cons of Paper Trading

By Colin Dodds | Financial Independence, Growing Wealth, invest, Investing | Comments Off

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 today, investors typically use digital platforms to virtually test out hypothetical investment portfolios, day-trading tactics, and broader investing strategies.

How do Paper Trades Work?

What is paper trading? 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.

💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

Pros and Cons of Paper Trading

Paper trading has both benefits and drawbacks. Here are a few factors to consider before you try paper trading.

The Pros of Paper Trading

Build skills: 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. It’s 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.

Test out strategies: 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.

Learn about strengths and weaknesses: 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 way for investors to learn their own tendencies and weaknesses without paying for the lesson.

Keep emotions out of it: Finally, paper trading can help 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.

The Cons of Paper Trading

It’s not real: 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.

The emotional impact is hard to gauge: Paper trading does limit 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.

Could be misleading: 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.

Doesn’t involve the true costs of trading: 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.

💡 Quick Tip: Are self-directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

Live Trading vs Paper Money

When an investor uses live trading, they are using real money to buy and/or sell stocks or other securities. They will confront market fluctuations and need to make decisions, sometimes quickly, about what to do. Live trading can be very stressful, but it does offer the opportunity for an investor to earn money. However, it also comes with the very real risk of losing money.

With paper trading, there is no money involved to lose. But once again, it’s not “real,” so while it may teach you some basics, paper trading does have limits and drawbacks, as detailed above.

Paper Trading in the Digital Age

Wondering how to paper trade? There are different ways to do it. 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 begin 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 some investors, this can be a valuable experience before they dive in with real money–and the potential for real losses.

How to start paper trading

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.

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 up their return.

If you decide to use a virtual trading 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.

Setting up a Paper Trading Account

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.

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

Do you make money from paper trading?

No. With paper trading, there is no real money involved, so there is no opportunity to make (or lose) money. Paper trading is a way to learn about trading without risking money.

How realistic is paper trading?

Paper trading involves using real trading strategies and simulates a real market experience. However there are no real losses or gains since no real money is involved. Because of that, it doesn’t convey a fully realistic experience.

Is paper trading good for beginners?

Paper trading can be a way to learn the basics of investing. A beginner could build their skills and test different strategies without risking loss. However, paper trading can be misleading because there is no real risk involved. An investor might be tempted to take more risks than they would in a real life investing scenario, for instance.

Why is paper trading important?

Paper trading could be important because it allows beginning investors to practice trades, build their skills, and test different market strategies, without the risk of losing money. However, it can’t replicate the experience of real trading with actual money and the potential to possibly lose money, which someone who tries paper trading should keep in mind.

Photo credit: iStock/fizkes

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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