Demo Accounts A Good (But Imperfect) Indicator Of Investing Skills

By Cory Mitchell AAA

Demo accounts are advertised all over the internet, and people who surf financial sites are often exposed to many ads inducing them to open a demo account. Demo account trading is the new form of paper trading. The old-fashioned paper trade involved writing down entries and exits to see how a methodology played out in the market. Demo accounts allow the trader to do this on a computerized simulator. The simulated trading environment does provide a trader with the opportunity to get used to the software they will be using with their broker to trade the markets, but when a person moves to live trading after the demo account, there are several shocks they need to prepare for. (Trade stocks and options on Investopedia's free Stock Market Simulator.)

Why the Shock?
Many traders trade profitably in a demo account, but when they move to live trading with their own money, a succession of losses may occur one after the other. Why does this happen?

  1. Demo accounts provide better execution than live trading.
    Demo accounts will normally fill a market order at the price showing on the screen. When an order is placed in the live market, it is subject to slippage, and therefore it is quite common for market orders to not be filled at the price expected, or in the case of large orders, for at least a portion of the position to be acquired at a different price than is expected.

    Demo accounts will also generally give early fills when bidding or offering. Bids and offers in the live market are also subject to a queue. Bidding at the current bid price does not guarantee a fill, as only a few shares or contracts may be filled at that price. In a demo account, it is hard to know which orders would actually have been executed in the live market. This is true of entries and exits, and thus results attained from a demo account are highly subjective at best, and completely inaccurate at worst. (See Understanding Order Execution for more.)

  2. Demo accounts often provide more capital than what the trader will actually be using for live trading.
    Demo software generally allows the trader to choose the amount of capital he or she would like to simulate trading with. The amounts vary, but are often very large and beyond the actual capital the trader has for trading his own account.

    Simulated trading with more capital than will actually be traded provides an unrealistic safety net. More capital allows for small losses to be more easily recouped, while a loss on a smaller account is harder to recoup.

    It is also important to note that even share lots (100 shares) in more expensive instruments, which were easy to afford in the high-capital demo account, may be beyond the capacity of the trader in a live account. The instruments and volume traded in the simulator may not be able to be replicated with real capital. A trader may be able to trade several lots of Google at $500/share, but unless he or she has similar capital for live trading, he or she may be unable to trade those higher priced instruments at all.

  3. A demo account cannot simulate the emotions of fear and hope (also called greed) that the trader will experience with real money.
    This is one of the most jarring differences between simulated and live trading. A fear of losing one's own capital can wreak havoc on a proven trading system and prevent the trader from implementing it properly. Greed (or hoping a losing position will come back to profitability) can have the same effect, keeping the trader in a trade long after it should have been exited.

    When real money is on the line, money that can have a potential material impact (or is perceived to have a potential impact), it is far different from trading a demo account where success or failure has no material impact on the person's life. (For more on this, see When Fear And Greed Take Over.)

Can Demo Trading Be Made More Realistic?
Demo trading does have some benefits, as it gives new traders a general idea of how the market and a company's software works. So, can you trade a demo account in a certain way to make it more realistic? While a demo account can never offer the same results that would be realized in live trading, there are several things you can do when testing out systems on a demo platform to make the results as realistic as possible.

  1. Make Realistic Assumptions
    If a bid or offer is placed, and you can see that the bid or offer was within one tick or one cent of the low or high of that move, assume that your order was not filled. The demo may show this order was filled, but in the actual market, this may not happen. Remove the profits or losses from these trades from the net profit/loss shown on the simulator – as if the trade never existed. Only assume bids or offers are filled if price trades through the bid or offer by at least a cent more. For thinly traded stocks or low-volume stocks this buffer should be expanded. (For more, read Gauging Support And Resistance With Price By Volume.)

  2. Account for Slippage
    On market orders assume at least a one-cent slippage on high volume stocks, and assume larger slippage in lower volume or more volatile stocks.

  3. Trade With Modest Capital
    If possible, trade the same amount of capital in the demo account as will be traded in the live market. If the demo does not allow this, trade only a fraction of the demo account capital. Don't access any funds from the demo capital which would be in excess of live trading funds.

  4. Get Personal
    Pretend the money is real as much as possible. Monitor emotions and how trades are affecting you psychologically while those emotions are felt. Since demo capital provides no real loss or profits, the sense of loss or profit needs to be added in by the trader. One method of doing this is to withhold something you enjoy if you fail to follow your trading plan, or give yourself a small reward when the trading plan is followed (regardless of profit or loss).

Summary
Demo accounts can provide some benefit to new traders, as they allow the trader to become familiar with trading software and get a sense of how the market works. The problem is that simulated results rarely correlate to actual trading results. Therefore, the trader must be aware that execution, capital and emotions can be different when trading real money as opposed to fake money. Traders can, however, make demos more realistic by excluding profits/losses on orders that are unlikely to have been filled in the real market, factoring in slippage, keeping the demo account capital in line with what will actually be traded and making demo losses and profits (and thus emotions) real by incorporating external stimulus.

(Use the Investopedia Stock Simulator to start implementing the tips learned in this article risk free!)

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