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Paper Trading, its Perks and Drawbacks

trading practice trading strategies Nov 27, 2020
Benefits and disadvantages of paper trading

Paper trading has become a regular offering in the financial world with many brokers offering paper trading services to their customers. However, as a trader, you need to know what it is and how it compares to live trading assets.

What Is Paper Trading?

A paper trade can be defined as a simulated trading process that allows a trader to practice buying and selling assets without risking real money. While paper trading is usually offered in demo accounts today, the term started before online trading came into existence. Aspiring traders would practice on paper before using real money in the live markets. During the practice period, the trader will record the trades on a paper to track the possible trading positions, profits, losses, and other metrics. The emergence of demo accounts and electronic stock market simulators makes paper trading feel like an actual trading platform.

Reasons for Paper Trading

There are various reasons for traders of all skill levels to use paper trading. Some of them include;

Gain Initial Trading Experience

For beginner traders, there is a whole lot to learn. Like other ventures, you need to practice trading before becoming an expert and gaining valuable market experience. You will need to figure out certain things, such as finding a strategy that works for you, scanning trading signals, opening and closing orders, managing winning orders, inserting stop losses, and more. You cannot gain all the experience as a newbie, so it is prudent to start with a paper trade account before funding a live account. Paper trading allows novice traders to learn a fair amount about order types and how to execute them. There is no dollar-risk involved, and the benefit is high as one gains screen-time.

Test New Strategies

If you have a new trading strategy you would like to try out, you can start by using a paper trade to see how it performs. If there is no stat available on how the strategy performs in the market, it is smart to use a paper trade to evaluate the performance of the strategy or setup. Paper trading is a solid option test strategies as opposed to dedicating a small amount of money and risk using a live account. Use the paper trading account to test your strategy for a few days or weeks to determine if it can potentially perform well in the live market or not.

Rekindle your Trading Expertise

Paper trading is useful even for the seasoned and experienced traders. Most traders go through losing periods, and the confidence level of the trader suffers during the losing streak. This can happen for several reasons, and it is a normal process. Regardless of the situation at play, it is a good move to step back from the live market and use paper-trading for a while.

What Should I Know from Paper Trading?

As a trader, there are certain things you will learn from using paper trading accounts. The paper trading accounts offered by most brokers allow investors to trade live markets without committing real capital. The trading process can be used to determine whether investment ideas have merit and can be able to generate profit.

The paper trading accounts help customers try options and various investment strategies without the risk of losing money. The accounts often have the same features as the live trading platform, whether the investor is trading with real money or not.

To obtain maximum benefits from paper trading, any investment decision you make and the trades you execute should be inline with real trading practices and goals. You should consider similar risk-return objectives, investment constraints, and trading horizon when using a paper trading account as you would when using the live trading option. This is to say that the trading conditions in the paper trading scenario should be the same as that of the real market. Investors and traders can get familiar with various order types like stop-loss, limit orders, and market orders. Other features you can understand include charts, quotes, and news feeds.

Paper Trading vs. Live Trading

When compared to live trading, paper trading has its perks and drawbacks. Let us examine them.

Advantages

  • Trading without risks: paper trading accounts such as demo accounts are important for first-time traders who wish to practice trading. It allows them to practice trading without the risk of losing money. It is smart to use paper trading accounts for learning trading and testing strategies instead of live trading accounts as that involves using real money. There is room for mistakes when using paper trading, and traders can easily learn from the mistakes, since no real money is at stake.
  • Understand how trading works: paper trading allows traders to understand how the market works. The demo accounts are loaded with virtual funds, which can be used to open long and short positions. The processes help traders to assess their actions, learn from them and get ready to start trading in their live trading account.

Disadvantages

  • A false sense of security: traders using the paper trading accounts may experience a false sense of security, which usually affects the investment results. Since paper trading doesn't involve risk of capital, traders might not conform to market events and instead make trades that would be harmful in the real market.
  • Delayed data: some paper trading accounts or demo accounts don't provide up-to-date information for traders. There is usually a 15-20 minute delay. Some platforms display estimated data to traders in a bid to convince them to deposit funds and start live trading with them.
  • Slippage: paper trading doesn’t account for market slippage, which is the real cost of getting in or out of the market.  You can allocate a certain commissions factor to paper trading to get a better idea of the expense associated with trading, but it is challenging to know what the actual cost of slippage will be.  Fast market conditions or wide the bid-to-ask spreads contribute to a very different reality from paper trading.
  • Shorts: paper traders would assume there is no issue with shorting stock, but the reality is that unless you are trading futures, options or CFD’s, you have to “borrow” the stock from your broker or clearing firm. The short may not be available, so therefore you wouldn’t have been able to participate, and paper trading doesn’t factor that in.

Final thoughts

Paper trading has become an essential part of the financial markets trading scene. It offers various benefits to traders, such as practicing how to trade, testing trading strategies, and more. However, paper trading has some drawbacks compared to live trading, as most traders don't take it seriously since no real money is involved. 

Use it for practice and testing ideas, but understand its limitations.

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