Imagine doing something that’s challenging or risky for the first time. That’s what paper trading in financial markets is—a trial run to get some practice that simulates the real thing. Most importantly, mistakes don’t matter because it’s not for keeps.
What are paper trades?
Paper trading gives investors a chance to get a feel for trading stocks, options, and other financial instruments without any real money at stake.
It’s called paper trading because before computers and online trading, investors would practice trades and record results in a notebook or on the back of an envelope—hence the idea of “paper gains” and “paper losses.” Now it’s often referred to as virtual trading because it’s done electronically. Either way, paper trading allows investors to build a running knowledge of markets and to analyze the hypothetical trading gains and losses, helping them to decide if they’re ready for the real thing.
Paper trading can be done by people with varying degrees of experience in financial markets. These include:
- Beginners: Paper trading gives novices a chance to learn the rules and mechanics of trading. Beginners may prefer practicing with simpler assets like stocks and index funds, and in small trades, including fractional shares of high-priced stocks or even micro versions of market index futures, which normally require large amounts of capital. Beginners can include people with limited experience in other markets; for example, an investor who trades stocks and now wants to try options.
- Day traders: These are investors who buy and sell frequently within a single day. They try to profit from small price moves and discrepancies, for example, buying shares in the morning at $50 and selling in the afternoon at $50.15. Day traders can use virtual platforms to test trading ideas, before committing to live trades.
- Professional traders: Investors who manage money can use simulated platforms to try out different strategies, such as spread trading to profit from the price differences between two securities. For example, the professional might buy call options on ABC Corp. with the right to buy at $50 a share, while selling ABC call options that give another investor the right to buy at $55.
How to practice paper trades
Investors who want to try paper trading can open a virtual practice account at their brokerage. Paper trading is generally free. Some brokers may require investors to open a regular brokerage account and put money in it, before beginning paper trades. Besides brokerages, there are some independent websites that offer paper trading.
Electronic stock market trading simulators are used, which mimic a real online trading platform. Most online brokerage platforms focus on the stock market, providing investors with market monitors, stocks-to-watch lists, and research from Wall Street analysts.
Brokers typically provide $100,000 of play money in the virtual account along with practice versions of trade order tickets and spreadsheets for keeping track of paper trades. Virtual accounts allow investors to become familiar with the procedures involved in real trading: entering buy or sell orders, tracking trades, and recording paper gains or losses.
Things to consider when choosing a paper-trading platform
Investors may have some questions before choosing an online paper-trading platform:
- How robust is the platform? The virtual trading experience should be as close to real as possible, so investors have a firm grasp of the essentials if they move to trading in live accounts. If a broker or other paper-trading service only offers a scaled-down demo version of real trading, it may not be as beneficial.
- Are displayed prices real-time or delayed? This might become important as investors transition to live trading. Delayed-price displays are typically about 15 minutes behind real-time prices. An investor using delayed prices for a paper trade could be unpleasantly surprised to see prices shift during that 15-minute window, making a real trade less profitable or even unprofitable.
- Will paper traders have access to market research, charts and other analytical tools?
- How much money is required to fund a regular brokerage account, in order to access paper trading? Are there any other costs to investors for use of simulated trading platforms?
Potential benefits and drawbacks of paper trading
Paper trading could benefit investors in several ways:
- No real money, no risk: Practice trading can be done without worrying about losses.
- No time pressure: Investors can spend weeks or months paper trading, researching companies and markets, and getting comfortable with the idea of trading.
- Good education: Investors can learn from mistakes and become familiar with the mechanics of a trading platform, before they consider venturing into real trading.
- No emotional distraction: Because it’s risk-free, paper trading allows investors to put emotions at arm’s length and ignore behavioral biases that tend to happen in real trading—like the urge to double down on a bad bet to try to recoup losses or sell amid a general market decline.
At the same time, there can be drawbacks to paper trading:
- No gain: Investors doing virtual trades may miss out on profitable real trading opportunities.
- Overconfidence: Some hypothetical gains in paper trading might make an investor a little cocky and prone to make trades that may not be appropriate for the investor’s risk tolerance. And a few successful paper trades aren’t a reliable indicator of long-term investment growth; it’s hard to beat the market over any stretch of time.
- It’s not for real: Paper trading simulates real trading but it’s still not the same thing. For instance, paper trading doesn’t take into account problems that can occur in brokers routing or filling orders, and prices may change by the time investor orders are executed, known as slippage. Finally, hypothetical trading doesn’t account for commissions and fees the broker may charge for live trades.
- Limited usefulness: Practicing paper trading may not be so useful to long-term investors, who buy and hold; trading entails frequent buying and selling of securities.
Paper trading vs. live trading
Paper trading is meant to prepare investors as much as possible for live trading, and the increasing availability and sophistication of online investing makes paper trading easy. They can use the time to understand different types of trading orders and they might test their nerve by trying paper trades at times of more volatile market conditions.
There are several steps investors can take to make sure that paper trading is as realistic as possible. For example, risk tolerance should be the same as if real money were at stake. The investment time horizon also should be the same. Active traders may think in terms of days, weeks, or months. Longer-term investors think in terms of years.
As part of building discipline, investors might impose boundaries on their trades by using different order types. These include:
- Market orders, instructing brokers to buy or sell at the going market price. Market orders are most suitable in times of low market volatility.
- Limit orders, telling brokers to pay no more or sell for no less in a trade.
- Stop orders, such as stop-loss orders to begin selling when an investment declines to a certain price, or buy-stop orders to begin buying when an asset price rises to a certain threshold.
The bottom line
Paper trading allows investors to familiarize themselves with how trading works for stocks, options, futures and other instruments, free from the risk of loss. Investors can use an array of services offered by brokers to let them practice trading and track the results, in preparation for real trading.
Paper trading, however, may not be of much use for long-term investors who buy and hold rather than trade regularly. Paper trading, like much real trading, is generally short-term in scope.