What is paper trading? Your guide to buying and selling without risk
Do you want to start trading stocks and other assets but fear losing your money? Are you new to investing and still learning how buying and selling assets works?
If you want to practice trading without risking any real money, you can try paper trading to learn the ropes.
What is paper trading and how does it work? In this article we provide a definition of paper trading and explain how it can teach you what you need to know in order to feel more confident about trading on live markets.
What is paper trading?
What does paper trading mean? A paper trading account is a practice account that uses virtual money. Paper trading is a way for new traders to learn how trading works, practice buying and selling assets and test out different trading strategies without risking any money. They can get to know the features of the trading platform and track their progress, so that they can feel more confident once they start trading in a live account.
Paper trading explained
In a virtual account, traders can set a virtual balance similar to what they plan to invest in real life and monitor how it would perform. They can start with small positions and gain experience to feel more confident in scaling up to larger ones.
A good paper trading account will update asset prices in real time and will simulate a paper trade in the same way as a real trade would be executed. The idea is to have an experience that is as close as possible to live buying and selling.
Traders can record their trades in a trading journal and analyse the data to determine what works, what doesn’t work and how to improve before they start live trading.
Advantages of paper trading
There are several reasons you should consider paper trading before you start trading in a real account:
Practice trading different instruments without risking real money
Access real-time quotes for a range of assets
Simulate live trading conditions to get an idea of how you will perform as a trader
Learn how to use price charts and indicators in technical analysis
Learn about different order types such as market orders, limit orders and stop-loss orders to help you manage positions and limit losses
Learn how to place buy and sell orders quickly and correctly
Become familiar with the functionality and tools of your specific trading platform, which can differ from other platforms you may have used before
Test different trading strategies on past or current prices to see how they would have performed and help decide which you will use in live trading.
Any mistakes do not lose real money
Practice trading even when the live markets are closed
But you should also keep in mind the shortcomings of paper trading.
Disadvantages of paper trading
Paper trading aims to simulate real market conditions as closely as possible, but there are reasons why the experience can vary:
As there is no live transaction, a paper trade does not take into account the effect of the trade on market liquidity. In live trading there can be slippage between the displayed price and the price on execution, which paper trading might not replicate.
Depending on the number of bids and offers in the real market, there are times not every trader can execute a trade at a certain price, so they can miss trades or get stuck in a position, whereas paper trading opens and closes positions at the trader’s desired price.
Profits can be smaller and losses bigger in a paper trading account than in a real account because of the nuances of live trading.
Traders can develop a false sense of security because they are not risking real money.
Note that some account providers limit how long you can use a practice account before being required to deposit real money.
History of paper trading
Where does the term ‘paper trading’ come from? Before the wide availability of electronic trading platforms, new traders would write out hypothetical trades on paper. Paper records were used to track potential positions, strategies, profits and losses without risking real money in the stock market.
These days, there’s no longer a need to record trades on paper, as online trading platforms offer virtual practice accounts that aim to replicate the look and feel of their live trading accounts.
Paper trading vs traditional trading
As we have seen above, there are some differences in paper trading vs real trading that can create distorted results. Paper trading is unable to take into account the challenge of following strategies when real money is invested. It can be easier to buy low and sell high in a practice account than in a live account when emotions can affect your judgement.
In the real markets, inexperienced traders can be hesitant to take profits or execute stop-losses in the hope that prices will rise and they can make larger profits or recoup losses. Paper trading offers new or even experienced traders a way to develop their skills and test setups to gain confidence in a trading approach without the pressure of risking real funds.
Changes in the market could prompt an experienced trader to use a paper account to test out new strategies based on the new market dynamics.
Once you make the move to a live trading account, take small positions and be aware of the differences in the psychology of paper trading and trading with real money. You could find that while you trade calmly with a paper account, you act irrationally when real money is involved. You will need to learn your personal risk tolerance and how you can minimise losses.
How to buy and sell without risk
Paper trading is one of the best ways to learn about investing without risking any of your real money.
However, once you start live trading, remember that you cannot completely avoid risk. It’s important to do your own research. Your decision to trade depends on your attitude to risk, your expertise in the market, the spread of your investment portfolio and how comfortable you feel about losing money. And never invest more than you can afford to lose.
FAQs
Is paper trading accurate?
Paper trading aims to simulate real market conditions as closely as possible. But there are nuances in live trading that a virtual account may not be able to capture, such as slippage and low liquidity.
How does paper trading work?
A paper trading account replicates a live account by giving you a virtual balance and the same trading tools such as price charting and technical analysis indicators. You can open and close trades using the different types of orders to understand how they work and test out different trading strategies. You can record and analyse your trades to find out what works and how you can improve as a trader.
Is paper trading worth it?
Paper trading is an effective way to learn the basics of how to trade without risking your money. But you should be aware of the differences between paper trading and live trading, and not become lulled into a false sense of security that could see you lose money when you make the switch to live trading.
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