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A Complete Guide to Paper Trades

S ome people want to trade stocks, but they are worried about getting it wrong. This level of caution is somewhat understandable as any investment in live trading means risking one’s money. Other people may be reluctant to begin trading due to general nervousness about whether it will work rather than a fear of losing their investment. Whatever the reason for your hesitancy, paper trading can provide a solution. This article offers a complete guide to paper trading, including tips, pros, and cons.

Key takeaways:

  • Paper trading is a simulated way to practice and gain experience in stock market trading basics.
  • There are a number of differences between paper trades and live trades, but the biggest is that emotions have a huge influence on live trading behavior. On the other hand, emotions have a negligible impact on paper trades.
  • To get the most out of paper trading, you should take thorough notes and analyze past trades. Investors should use the results of paper trading to inform their trading strategies in live markets.

What is Paper Trading?

Image via Pixabay by AhmadArdity

A paper trade is a simulated trade that enables beginner investors to test out their buying and selling strategies without risking their own money in the stock market. Using an online market simulator, investors are able to practice trading virtually rather than investing in live markets.

Paper trading originated from a time when aspiring investors practiced by writing down hypothetical trading positions and gains and losses on paper. Nowadays, you don’t need to go to the effort of writing everything down; you can use an online stock market simulator instead.

Paper Trading Pros and Cons

The main benefits of paper trading are as follows:

  • Risk-free: Investors don’t need to risk any money when paper trading.
  • Stress-free: Investors can focus on learning how to execute trades and improving trading strategies without the stressful emotions that come up when real money is on the line.
  • Useful learning tool: Paper trades can provide data-driven insights that help investors improve their knowledge about trading stocks.
  • Develops confidence: A novice investor can develop confidence from understanding how to execute trades and earning gains from positions taken during paper trading.

Paper trading also as some drawbacks:

  • It doesn’t factor in correlation: The movement in individual stocks often correlates with the movements of the broader market. During periods of high correlation, individual positions taken during paper trades may have impacted results far less than the broader market conditions.
  • Real trades have commissions: When trading in live markets, there are various commissions to be taken into account that don’t play a part in paper trades. With commissions, the same stock that you think costs $20 per share in a paper trade might cost $20.50 per share in the live market due to commissions.
  • There’s an emotional disconnect: It’s easy to be emotionally disconnected from decisions made during paper trades because there’s nothing on the line other than arbitrary movements in fake money.

Paper Trading vs. Live Trading

An important point to remember is that everything about a paper trade is simulated, including the emotions one feels when trading. There is no inherent risk to your capital when paper trading, which invariably leads to a certain calmness that is difficult to replicate when money is actually on the line. Furthermore, good results in paper trading can provide a false sense of security — you might not take the same risks in a live trade as you do while paper trading.

In live trades, real money is being invested. When people risk their capital, emotions become a huge factor in any decisions that are made. These emotions can affect behavior in live trading, which increases the gap between how buying and selling happen during a simulated trade versus in live markets. Successful investors have learned to control their emotions while under pressure, but it’s unrealistic to expect this same composure when you first enter live markets.

Another difference to note is the liquidity of paper trades versus live trades. When paper trading, liquidity is not an issue, and you can buy or sell stocks in any desirable volume. In live markets, the desired position size might not be so available.

Aspiring traders should keep in mind that the main goal of paper trading is to learn how to properly execute trades and develop basic trading strategies without risking any money. Establishing a successful trading mindset tends to come with experience from live markets.

Paper Trading Tips

Paper trading offers a great opportunity to learn about stock market basics and is a practical way to understand, prepare, and test various trading strategies. Here are some useful tips to get the most out of a paper trade:

Take Thorough Notes

Gone are the days in which the entire practice of paper trading was done by putting pen to paper and recording everything. However, even though online market simulators make it easier to paper trade, it’s a good idea to take your own notes. The more thorough your notes are, the more you can learn about the different trading decisions you made and whether they worked for you.

Consider writing down why you entered and exited each trade, how many shares you bought and why you chose that amount, whether the trade achieved your desired outcome, and what the risk-reward profile of the trade was. This information can provide you with data to analyze at a later point. Data-driven insights can lead to marked improvements in trading strategies.

Use a Realistic Investment

Most simulated trading platforms allow investors to create accounts with unrealistic investments. It can be understandably tempting to start paper trading with an investment of, say, $1 million, but it’s also entirely unrealistic for most beginner traders. The best way to learn from paper trading is to use an investment amount that you would fund a live trading account with.

A big reason to use a realistic investment is that it puts losses and gains in perspective. Investors using an unrealistic amount of money in their paper trading accounts might not think a decision that results in losing $1,000 is bad. However, when viewed through the lens of losing the same $1,000 on a planned $3,000 investment in live trading, that loss is consequential, and the decisions that led to it warrant further analysis.

Similarly, buying 100 shares priced at $100 per share and selling those shares at $101 per share looks good because it gives an easy $1,000 gain, but when the initial investment portfolio is just $2,000, the gain is much less impressive.

Analyze Results

The mere practice of paper trading can be useful, but it’s arguably the post-trading analysis that gives you the best insights. Taking thorough notes provides lots of data to learn from, but this data can only be learned by going back and looking at trades. Investors need to become adept at spotting patterns that led to gains and factors that led to losses.

By analyzing paper trades in-depth, investors can get actionable takeaways about what they are good at and what positions they tend to lose money from before they risk real money on the live market.

Repeat the Process

I t’s a good idea to repeat the process of paper trading over several iterations, which includes placing realistic trades, taking notes, analyzing results, and finding actionable takeaways. Each new takeaway can be used to inform another round of paper trading. For example, if you see that you tend to lose money on long trades, repeat the process while sticking to short trades, and analyze your results.

Keeping these tips in mind, beginner investors can consider going live when they feel they’ve developed a solid understanding of how to execute trades and which strategies work best for them. If you find that your live trades perform poorly compared to your paper trades, you can always go back to paper trading and continue to improve your trading strategies.