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Paper Trading – What is it and how does it work?

paper trading
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Paper trading has a long history as the concept originated long before the advent of the Internet and online-based trading platforms. Back in the days before online demo accounts became popular, stock traders, who were just starting their day trading careers, would write down at what price they wanted to buy or sell a stock. By the end of the day, these novice traders would compare the market price with their entry price and try to measure their speculative performance. In this article, we give you a few tips and talk in-depth about what is paper trading and how to use it.

What is Paper Trading?

The best aspect of paper trading is that you get to experience trading without risking a single penny.

However, the concept of paper trading has evolved over a few decades as trading became more digitized. Now, traders do not need to use a pen and a piece of paper to track their so-called “open positions.” Instead, most trading platforms offer traders a built-in demo trading account where they can mimic the trading experience of live trading and try out all the bells and whistles that the platform has to offer.

In a nutshell, if you wanted to buy a stock and the stock price closed below your market entry price, you would register a loss. On the other hand, if you wanted to short the stock and the stock price ended up closing above your market entry, you would call it a loss. With paper trading, you may want to note down how many losses you made as opposed to winning in monetary value. Or, you may simply want to evaluate the performance of a trading strategy in terms of the win rate, the risk to reward ratios, and the overall profitability of the system.

Nowadays, the process of paper trading with a demo account appears almost identical to trading with real money. However, the key difference is of course that with paper trading with a demo account, you are not putting your hard-earned capital on the line. Instead, you are trading with virtual money to test the trading platform, your own trading strategy, and can develop confidence in your day trading ability.

While the concept and application of paper trading to improve your actual trading may appear to be a simple endeavor, there is more to paper trading than meets the eye.

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The benefits of paper trading

  • You can use paper trading to explore your comfort zone.
  • It can help you earn the confidence you need to deal with stress while trading with live funds.
  • You can test your strategy to see if it’s viable on the market.

Once you have learned to execute trades on a demo trading account, you can further hone your money management skills to avoid trading more than your account can support. Moreover, while paper trading, you can try out different order placement methods like using pending stop and limit orders to get comfortable and discover your preferred way of trading. You also trade the markets on different time frames to see how you are psychologically conditioned to deal with a fast-moving price on a five-minute chart compared to trading on a daily chart.

While doing all of these on a paper trading account will add up to building your confidence, the most important aspect would be learning if you can trade profitability over a certain number of weeks and months. If you can trade profitably for several consecutive months, it will work wonders to build your confidence.

How does paper trading works? Important tips to start

If you’re starting and have no idea of what a simulated account is and how it can help you improve, we have here a few valuable tips that can help you improve your trading skills. See below how these tips can make you a better trader.

It Can Help You Gain Confidence

Most people grow up to admire certainty. Partly because most skills we learn in schools have hardly any ambiguity to it. In most jobs, two plus two always add up to four. However, the nature of trading is dealing with uncertainty and risks.

While professional traders, who come from a finance background, are often trained to quantify uncertainty, most retail traders do not have any clue about how to cope with the stress that is the part and parcel dealing with risks and being a day trader.

Sure, you can have the best trading strategy, ample capital to engage in the market, and have all the confidence in the world to do your day job properly. But, if you don’t know how to deal with uncertainty and risks, trading stocks or Forex can end up being a stressful endeavor that can crush your self-confidence and destroy your trading career.

However, if you start with paper trading, it can help you earn the confidence you need to deal with stress while trading with live funds.

By contrast, if you know that you do not have the patience to sit in front of a screen the whole day, you can start looking for more short-term oriented trading systems such as using a 5 and 20-period moving average cross.

If you can use paper trading to explore your comfort zone, you can become confident in your ability to trade and it will help you become profitable in the end. Imagine paper trading as a virtual reality cockpit and you are training to become a pilot who will someday maneuver a multi-million-dollar aircraft!

Would you suddenly sit in the real cockpit and have the confidence to fly a Boeing 777? Probably not. Well, definitely not for most people!

Match Your Paper Trading Account Balance to Your Live Account

If you have visited any broker’s website, then you have probably seen the advertisements for free $50,000 paper trading accounts. Well, when you are trading with virtual money, it really does not matter if you have $50,000 in your account or a million.

However, there is a strong case for keeping your demo account balance close to what you would be trading in your real or live account. As far as human psychology goes, we are slaves to our habits. When it comes to trading, we are prone to assign value to the changing numbers that correspond to our short-term memory or experiences.

If you are a retail trader who wants to start trading with only $10,000 but starts trading a paper trading account that has a starting balance of $100,000, guess what can go wrong? First, you will train your brain to see much higher numbers in the profit and loss column of your account statement. Second, when you would calculate your position size, hopefully, based on a sound money management system, your orders will be ten times higher than what you would be normally trading with a real account.

Paper trading account with a balance of $100,000

  • A loss of $1,000 is 1% of your account balance
  • Orders 10x bigger
  • You train your brain to see much higher numbers in your P&L column

Live trading account with a balance of $10,000

  • A loss of $1,000 is 10% of your account balance
  • You might feel desensitized to relatively smaller losses
  • You may hold your losses for too long hoping they’ll reverse

There’s no guaranteed negative effect

We are not saying that it will certainly have a negative effect on how you trade. Nonetheless, as you train your brain to deal with larger numbers during paper trading, it can certainly mess with your value compass. Especially, if you are just starting out as a trader.

Once you switch to a live account that has a much lower account balance, you might feel emotionally desensitized to relatively smaller losses. For example, if you have been risking $1,000 per trade on a $100,000 demo account and suddenly switch to a $10,000 live account, then seeing a $500 loss may not trigger an alarm when it definitely should.

A lot of beginner traders make the mistake of holding on to their losses for longer than they should in hope that the market will soon reverse. It may sound counter-intuitive, but the larger the accumulated losses, the harder it becomes for novice traders to accept it. Hence, trading with a large demo account can have a negative effect on how you deal with stress and assign a value to the capital in your account when it comes to live trading.

Use It to Avoid Curve Fitted Systems

You have probably heard about backtesting, which is essentially the process of finding out if a strategy would have worked in the past. If you Google it, you will find thousands of “profitable trading strategies” for sale where the developer promises you an outrageous rate of return on your investment.

The problem is, most of these ready-made trading systems are created by curve fitting. Developing a profitable strategy is hard work. But, if you look at a chart history and tweak your indicator settings to match the historical data, you can easily make your system appear to be working like magic.

Hence, when you come across a system that is claiming to offer extraordinary returns, always make sure you try out the system for several months with a mixture of assets and timeframes on a paper trading account before you start trading it with your live account.

Trading a system with a demo account in real-time is called forward testing. When you forward the test, you can also play around with certain parameters of the system to match your personal trading style that suits your comfort zone.

Some veteran traders say that forward testing with a paper trading account does not give them a realistic psychological experience as no real money is lost or gained. Hence, they advocate traders to open micro trading accounts and trade pennies to get the feeling.

However, when you are forward testing, it is always better to test a system out with paper money instead of risking even pennies. After all, you can always forward test a system for a few weeks before trying out with your micro account and if all goes well, trade your larger account with the system later.

Professional Traders Do More Paper Trading than Actual Live Trading

When you are just starting out as a trader, you are often eager to start trading with real money. The majority of novice traders often find the inherent risks associated with trading as a source of excitement and not something to be worried about.

That’s why a lot of people associate inexperienced retail traders with gamblers because both groups demonstrate similar types of character traits.

On the contrary, professional traders with years of experience under their belt will tell you that they are often spending the majority of their day trading paper money.

You see, professional traders do not trade to win a particular trade. They trade a system.

The key difference between a professional trader and a novice trader is that when it comes to uncertainty and taking risks, professionals try to act like the Casino while the latter group acts like the gamblers at the Casino.

what is paper trading

While most inexperienced traders are worried about the outcome of a single trade, probably because they are overexposed or betting 10 percent of their account on a trade, professional traders are much more meticulous about the whole process.

Institutional traders know that their system offers them an edge over the market and if they strictly follow their rules, over a series of 100 trades, they will win a certain percentage with a certain risk to reward ratio that will make them profitable.

That’s why professional traders take their paper trading very seriously. While they are waiting for the market to present them with the perfect entry opportunity, they are not just sitting on the hands waiting. They are paper trading to test drive their new strategies that may offer better profitability than the current system.

A Demo Account is No Substitute for a Real Account

Keep in mind that paper trading is not a substitute for trading with a real account. In fact, if you trade a demo account for extensive periods of time, it can backfire and have a negative impact on your trading career later on.

You see, paper trading has no consequences. With paper trading, you only invest your time and have no “skin in the game.” If you want to gain trading experience, a paper trading account simply will not be adequate.

From an evolutionary perspective, humans have evolved to deal with risky situations by releasing a hormone called adrenaline that prepares our bodies and minds to clear and present danger. When you paper trade, you do not feel this adrenaline rush that manifests itself by a physical feeling of intense excitement and stimulation.

To become a seasoned trader, you need to have hours of “screen time” with a real account to get familiarized with this sensation of dealing with adrenaline in your bloodstream.

Regardless of how good you get or how profitable you become with a demo account unless you have risked real money and went through the roller coaster ride of dealing with losing or making money in the market, you have not really experienced what it feels like to trade.

At the end of the day, trading is a game of psychology where the market tests how emotionally stable and resilient you are. Hence, emotional stability and discipline are what separate the profitable traders from the amateurs. This is why only a tiny fraction of traders end up earning all the profits in the market and the majority loses in the long run.

The Bottom Line

You will never learn to trade properly unless you have accepted the fact that trading involves accepting losses, if not embracing it. All trading systems, regardless of how accurate they are, will make some losses. The way to become a profitable trader is thinking in terms of statistics where you will place ten trades with exactly the same criteria. Maybe the majority of them will be profitable while you will end up losing a few. But, in the long run, your system will emerge as a profitable one.

Unfortunately, paper trading will never prepare you for the real world of trading as demo accounts lack the emotional connection between your capital and your capability to tolerate risk.

However, demo accounts will never give you the sensation of seeing a large loss and coping with realizing the loss. This is the bitter pill you have to swallow on a live account day in, day out to get familiar with your comfort zone.

Unless you are emotionally conditioned to see a large loss and realizing it instead of moving your stop loss further in the hope that the market may turn in your favor, you can never become a successful trader.

Having said that, demo accounts can still play a functional role in helping you get used to the world of trading in terms of knowing how to trade or learning how to manage your money. If you successfully paper trade for a few months and see you are constantly becoming profitable, do not wait too long to start trading with a live account as you want to get into the game as early as possible.

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