Have you had a chance to experience virtual reality (VR) yet?
It’s pretty cool. And the possibilities are endless. Just consider:
Being able to train emergency medical response teams without a critical situation actually happening, or creating simulations for pilots to learn how to fly in dangerous and faulty conditions.
It creates the perfect environment where you can learn through experience – without taking all the risk.
Now, the stock market doesn’t exactly have a VR equivalent. It does however have a simulation you can participate in. The simulation is essentially a stock market testing ground known as paper trading.
Paper trading works similarly to a flight simulator – you can perform fundamental and technical analysis, while practicing different moves, strategies, and approaches to trading – without any of the real consequences.
This means you can practice trading – without the risk.
Let’s dive in and explore how paper trading really works.
What you’ll learn
What is Paper Trading – Exactly?
Paper trading is a trading simulation where people can trade securities through a simulation of the stock market without having any financial consequences. “Paper” refers to how investors used to trade if they wanted to practice, where they’d write their trade on paper before investing money in the live market.
Simulations have been incredibly useful in recent years following the development of technology. Their applications in the medical field, as we just touched on, have allowed medical professionals to practice emergencies with no real risk involved.
This is why trading simulations were developed – allowing investors to practice trading without taking on any real risk.
What Can Investors Learn From Paper Trading?
Investors can learn a lot from paper trading. In fact, you can learn just about everything that you could through live trading. The goal is to understand cause and effect relationships through experimentation, and this can be useful to rookies, veterans, and everyone in between.
For traders just getting started, paper trading allows them to see how the stock market works. They can get the basics down before risking their capital. Beginners might also use trade alerts to be notified of portfolio moves from other veteran traders. Using alerts – and practicing those moves with a risk-free paper trading account – is a great way to jump into the market without much experience.
For veterans who already know the ins and outs of the stock market, they get the opportunity to test new strategies. Maybe they recognize that a bull run is ending and they want to adjust their strategy, so they test a bearish technique such as the bear put spread with a paper trading account (also referred to as a demo account) before seeing how it plays out live.
An Example of a Paper Trade
Let’s say that an investor who frequently invests is interested in trying a new strategy, but doesn’t want to put real money towards it before they can see if it’s effective. Luckily paper trading allows them to do just that.
Let’s say they want to test a strategy that allows them to scrape off profits every time the S&P 500 dips a little bit in a bull market. They’re thinking that if there is a bull market, and there are periodic dips in the S&P, followed by a short term recovery, they could buy SPY at the dip, and sell when it rebounds to scrape off some profit.
So the investor patiently watches the market until they notice a dip similar to the ones they had been seeing, so they place a trade for 15 shares of SPY. They hold the position, and watch in the following days as SPY continues to fall. Thinking that the dip would only last a day or two as it had before, and not several days, they decide to sell their position because they think that the downtrend may continue.
A couple days later they see that the S&P as recovered to where it was before the dip, and the investor realizes that maybe they should hold the position for just a little longer while the trend is completed, and then keep holding as it reverses. They write down what they learned and try it a few more times. After they have a nice log of trades, and have realized consistent success, they decide to take the strategy to their live account.
This is one example of how an investor can use paper trading, but there are loads of different possibilities you can explore.
Just keep in mind that once a trader decides to trade options with a live account, they’ll need to apply for specific options trading levels with their broker in order to access the more sophisticated options plays.
Pros and Cons of Paper Trading with a Demo Account
Being consistently successful has so much to do with learning about yourself. Seeing what your tendencies are, what strategies you tend to gravitate more to, and perhaps also what your biases are. And the path of self-exploration is inherently a bumpy one, so why not smooth the road a bit with paper trading? So don’t be afraid to experiment a little, maybe try things that you normally wouldn’t so that you can gain perspective, maybe you’ll discover something that you normally wouldn’t. Be curious!
Now, many will say that it is not effective to trade differently with paper trading as you would with a live account and this is a valid point. If you are aimlessly placing paper trades, there is not very much room for a lesson to be learned there, and this can be a major disadvantage to paper trading, essentially distracting from how you’d normally trade because “why not?”.
For example, if you don’t know very much about options and you normally swing trade, and then decide to place a load of options trades in your paper account just to see what happens, you aren’t going to learn very much. If instead you decided to swing trade the same stock you have been for a while in your live account, but experiment with using a different set of indicators, that would be a great way to add to your strategy.
The key here is to make sure that you translate what you learn from paper trading and the outcomes of decisions effectively into your live trading strategy.
Paper Trading Effectively
The path and process to success is often a series of failing, tweaking, trying again; failing, tweaking, etc, until you’ve whittled down a nice formula for success, figuring out what works and what doesn’t. This means that it’s not always effective to trade in the same way with your paper account as you would your live account because you can try all of the things you might normally be reluctant to, and through that hopefully discover things you wouldn’t with a live account.
One type of order you can employ that many traders use to place effective trades is the stop loss order. Stop losses are great because they’re always watching your positions, even when you might not be. Here’s how they work:
You decide that you want to buy a stock, let’s say it’s Microsoft (MSFT), and you feel that the price will go up, so you long 10 shares, but you’re concerned about the possibility of it going down, considering the market has been a bit shaky at the time you bought MSFT.
To protect yourself from losing big in the case that the price does plummet, you can place a stop loss order. This is when you set a price that the position will automatically sell at. So say that the current price is $250, and you’re not comfortable losing more than $10 a share, you place a stop loss order at $240. That way if the price falls to that, it will automatically sell.
Another thing that traders specifically use paper trading for is to experiment with position sizing. There are many different ways to use position sizing to change the level of risk you take on, and therefore change the potential for profit. A more aggressive strategy would use a larger percentage of capital in an overall portfolio, aiming to capture more profit than a position with a much smaller percentage of capital. Using paper trading to find where you fall on the moderate-to-aggressive scale is a very effective way to trade.
Now, the essence of paper trading can be lost if investors are throwing money at anything and everything, trading with overconfidence fueled by the euphoria of making decisions without risk. It turns more into a video game than a simulation tool. The best part is, you can take paper trading as seriously as you’d like, whatever feels right for what you’re trying to accomplish.
Live Accounts vs. Paper Trade Accounts
One thing we haven’t touched on yet that’s a crucial component to trading is the emotions involved. One thing that tends to happen when you have money at stake in something, is you become not only financially invested, but emotionally invested. For example, someone that doesn’t really care about football but puts $20 down on a Super Bowl game is all of a sudden their team’s biggest fan.
The point is, when we have something to lose, we care more. This idea plays an interesting role when comparing live accounts with paper accounts. On the one hand, if you aren’t getting emotionally invested in your trades, you could end up trading well because you aren’t subject to the normal overthinking, hesitations, etcetera, that you might be if you’re live trading.
On the other hand, it could be beneficial for investors that have something to lose. Perhaps no matter what they just can’t fully separate themselves from the fact that paper trading is a simulation. Seeing how emotions influence investment decisions is something that’s discovered by the individual.
Another thing you’ll notice if you have a paper account is that the stock market data can be delayed. On TD Ameritrade the delay is 15 minutes. That means that if you are looking at the share price of a stock, the price you are looking at on your paper account is 15 minutes behind the live price. So it’s in investors’ best interests to have a way to check live data.
Four Reasons to Try Paper Trading
Before we conclude, we thought we’d wrap this up with four reasons to try paper trading:
- You get experience. Out of all the strategies, tools, trading tips and tricks out there – experience takes the cake in terms of how important it is to realize consistent success in the market. One of the things that comes with experience, though, is oftentimes experiences situations that do not work in your favor. Luckily with paper trading, you get all the experience, but there are no consequences for making an unfavorable decision.
- It’s an opportunity to test drive. There might be strategies that you have been curious to try but have been more or less reluctant because you have real money at stake in your live account. Paper trading is just the place to try all of those strategies out! You can feel out what works and what doesn’t.
- You learn to trade with less emotion. Now, paper trading doesn’t turn you into a stone cold trader, but certainly can allow you to see things a little more clearly. Investors have always, and will forever make mistakes when trading because decisions they make are emotionally fueled. If greed, fear, sadness are like fungi that grow in the fertile field of our mind, then paper trading is the bone dry, sterile desert that doesn’t allow those things to grow. The point is, you learn to trade with less, or no emotion, which is important when you live trade because logic plays such a big role in effective investment decisions.
- It’s readily accessible. There are tons of different places where you can paper trade, and they’re generally quite easy to set up. The barrier of entry is super low. So for those with internet access and an interest in investing, there aren’t too many reasons not to just give it a shot!
Paper trading is a fantastic tool for traders just getting started, for seasoned veterans, and everyone in between. Allowing beginners to learn about the stock market without any financial consequences, and veterans the opportunity to test new strategies.
The Trading Analyst’s own strategy has been back tested for years – and we’re always exploring new ways to improve it. In addition to always implementing crucial risk management factors, the use of paper trading is a great – and safe – way to put such new ideas to use.
Without consequences, though, our perception can change. Lessons tend to hit harder if there are consequences, whether they’re good or bad. Emotions enter the equation. The key is to properly incorporate and translate what you learn from paper trading into your live trading to be the most effective.
So again, experiment! Try things out, write them down, bring into your strategy what works, and do away with what doesn’t. Use paper trading platforms as a testing ground, it’s what they’re there for.
Paper Trading: FAQs
Can You Make Money Paper Trading?
No, you cannot make money paper trading because the money you ‘earn’ is not real. The purpose of paper trading is to be able to trade without financial consequences, and if you have no financial consequences, it wouldn’t make sense to be able to earn money.
How Do You Use Paper Trading?
Paper trading can be used in a myriad of ways. Beginners can use it to familiarize themselves with the complexities of the stock market, perhaps testing to see what happens if they bought a few shares of a stock.
And veterans can and do use paper trading too. They can test advanced strategies that they might otherwise be reluctant to try in their live accounts.
Then everyone in between. It’s a testing ground for any investment idea you have!
Why is Paper Trading Important?
Paper trading is important to every type of trader, no matter how much experience they have. And for all types of investors, it’s important to them because they have the opportunity to try something out if they’re new to it, for example. Like a pilot that’s just starting to learn how to fly a plane.
How Do I Start Trading Papers?
There are loads of brokerages that offer paper trading. Perhaps the most popular is TD Ameritrade’s platform “thinkorswim”. A quick google search for paper trading on the stock market and you’ll find heaps of results to get you started. With TD Ameritrade’s paper account selected, you start with $200,000.
Is Paper Trading Good for Beginners?
Paper trading is great for beginners! When you’re just getting started, you might not even know what a “share” of a company means, so buying shares with live money wouldn’t be the best idea. Paper trading is just as good, if not better for beginners as it is for the more experienced.
What Are the Benefits of Paper Trading?
The benefit to paper trading is that there is no risk of losing money, as it’s impossible to. This means you can trade risk and stress-free, while also getting the opportunity to develop your strategies, or even just get your feet wet investing.