What Is Paper Trade?
A paper trade is a simulated trade that allows an investor to practice buying and selling without risking real money. The term dates back to a time when (before the proliferation of online trading platforms) aspiring traders would practice on paper before risking money in live markets. While learning, a paper trader records all trades by hand to keep track of hypothetical trading positions, portfolios, and profits or losses. Today, most practice trading involves the use of an electronic stock market simulator, which looks and feels like an actual trading platform.
- Paper trading is simulated trading that allows investors to practice buying and selling securities.
- Paper trading can test a new investment strategy before employing it in a live account.
- Many online brokers offer clients paper trade accounts.
- Paper trades teach novices how to navigate platforms and make trades, but may not represent the true emotions that occur during real market conditions.
What Does Paper Trading Tell You?
The development of online trading platforms and software has increased the ease and popularity of paper trading. Today's simulators allow investors to trade live markets without the commitment of actual capital and the process can help to gauge whether investment ideas have merit. Online brokers such as TradeStation, Fidelity, and TD Ameritrade's thinkorswim offer clients paper trading simulators.
For example, TD Ameritrade's paperMoney® is designed to help customers try options and different investment strategies without the worry of losing any money. Nearly everything about the simulator is the same as their feature-rich thinkorswim trading platform, except the investor is not trading real money. Investopedia provides a free simulator for trading stocks.
To get the most benefits from paper trading, an investment decision and the placing of trades should follow real trading practices and objectives. The paper investor should consider the same risk-return objectives, investment constraints, and trading horizon as they would use with a live account. For example, it would make little sense for a risk-averse long-term investor to practice numerous short-term trades like a day trader.
Also, paper transactions can be applied to many market conditions. As an example, a trade placed in a market characterized by high levels of market volatility is likely to result in higher slippage costs due to wider spreads compared to a market that is moving in an orderly manner. Slippage occurs when a trader obtains a different price than expected from the time the trade is initiated to the time the trade is made.
Investors and traders can use simulated trading to familiarize themselves with various order types such as stop-loss, limit orders, and market orders. Charts, quotes, and news feeds are available on many platforms as well.
Paper Trade Accounts vs. Live Accounts
Paper trading may provide a false sense of security and often results in distorted investment returns. In other words, nonconformity with the real market happens because paper trading does not involve the risk of real genuine capital. Also, paper trading allows for basic investment strategies—such as buying low and selling high—which are more challenging to adhere to in real life, but are relatively easy to achieve while paper trading.
The fact is that investors and traders are likely to exhibit different emotions and judgment when risking real money, which may lead them to different behavior when operating a live account. For example, consider a real trade by a new foreign exchange trader who enters into a long position with the euro against the U.S. dollar ahead of nonfarm payrolls data. If the report is much better than expected and the euro drops sharply, then the trader may double down in an attempt to recoup losses in a paper trade, as opposed to taking the loss as would be advisable in a real trade.