What is ‘Paper Trade’
A paper trade refers to using simulated trading to practice buying and selling securities without actual money being involved. While a paper trade can be done by simply keeping track of hypothetical trading positions, it usually involves the use of a stock market simulator that has the look and feel of an actual stock market where investors of all levels can hone their trading skills.
BREAKING DOWN ‘Paper Trade’
The proliferation of online trading platforms has made it easy to practice paper trading without committing actual capital. Another benefit of a paper trade is that it can be used to test a new investment strategy before transferring it to a live account. To derive the most benefit from paper trading, it should be taken seriously, with investment decisions made based on the same risk-return objectives, investment constraints and trading horizon as if it was a live account. For example, if you are a risk-averse investor, it would make little sense to paper trade like a day trader and make numerous short-term trades. Online brokers such as Scottrade, Fidelity and TD Ameritrade offer clients paper trade accounts. Investopedia offers a free stock simulator that can be used to paper trade.
Paper Trade to Test Order Types and Market Conditions
When placing a paper trade, investors and traders should familiarize themselves with various order types such as stop-loss, limit and market. Placing a paper trader trade should be done under various market conditions; a trade placed in a market characterized by high levels of market volatility is likely to result in higher slippage costs due to wider spreads, compared to a market that is moving in an orderly manner.
Paper Trade Accounts vs. Live Accounts
Paper trading may give novice investors or traders the impression that trading is relatively easy, giving a false sense of security, typically resulting in distorted investment returns. This is because paper trading does not involve risking genuine capital. As a result, basic investment strategies such as buying low and selling high, which are difficult to adhere to in real life, appear relatively easy to achieve while paper trading.
Paper Trade Psychology
Investors and traders are likely exhibit different emotions and judgement when risking their own money that may result in them acting irrationally when operating a live account. For example, a new foreign exchange (forex) trader may enter a long position in the euro against the U.S. dollar ahead of nonfarm payrolls data. If the data was much better than expected, and the euro dropped sharply, the trader may double down in an attempt to recoup losses as opposed to taking the loss if it was a paper trade as no real capital was lost.