What is paper trading?

Paper trading is the name given to trading simulations where investors can practice trading assets risking no real money. The name paper trading came about because it used to be commonplace for traders to write their trades on paper and then compare the actual results later. With the advent of computers and software applications, few traders use paper any longer. Instead, there are trading simulators used, which look and feel like actual markets.

Benefits of Paper Trading

Paper trading is easy these days because nearly every online trading platform has paper trading capabilities. Online brokers offer paper trading accounts for stocks, forex and commodities. One of the greatest benefits for traders is they can use paper trading to test a new trading strategy before using it in a real money account. To get the most from paper trading the investor should use the same parameters, risk profile, trade horizon and constraints as they would have when trading with real money. For example, it makes no sense for an investor who is mostly concerned with income-generating stocks to paper trade like a day trader and makes short-term, high-risk trades.

Paper Trading vs. Live Trading

One downside to paper trading is that it can give new traders the impression that trading is easy. Paper trading can give a skewed sense of security as it can often provide returns distorted by back testing. Another reason paper trading can give different results from real trading is because there is no real risk involved. This results in a false sense of security for the new trader who often behaves differently when real money is on the line. Paper trading rarely creates emotions such as fear and greed, which can color a trader’s judgment when trading with real money in a live account. These emotions can lead to traders doubling down to try to recoup losses or holding a trade too long in hopes of greater profits, only to watch the profits they initially had evaporate. Traders need to be careful of the psychological implications of paper trading vs. live trading.