Paper trading is a simulated market environment in which the participant writes down buying and selling decisions, rather than placing actual orders at a brokerage. The process can be simple, with a few numbers jotted on a napkin, or complex, with spreadsheets breaking multiple elements into component parts for reflection and analysis. New traders are often instructed to paper trade until they learn basic strategies, while many experienced traders utilize the practice from time to time, especially when working on new ideas and approaches.
In theory, paper trading can build insight and improve skill sets at every step in a trader's journey, from novice to market professional. But does it really work as intended, or are there better ways to develop ideas and strategies? What are the key benefits and limitations, and how can market novices get the most value from the experience? Finally, can paper trading actually hurt financial performance, rather than help it?
Ways to Paper Trade
The simplest approach to paper trading identifies an appealing stock through a chart on a website or an analysis by a market personality, writes down the ticker and chooses a time to place a hypothetical buy order (or sell order if desiring to sell short). The novice jots down the opening price if entering at the start of the session, or watches the chart and ticker during the trading day, picking a spot that looks like a good entry.
The choice of entry price and time varies considerably, depending on the basic tutorials used to learn the trading game. The same holds true during the management phase, when deciding where to place the stop and how long to hold the position. Whatever the approach, an exit price is finally written down, and the novice repeats the process until enough data is gathered to analyze progress.
While pen and paper works perfectly well for paper trading, the spreadsheet provides a more powerful analytical tool for detail-oriented individuals because they can add additional columns to capture:
- stop placement
- time of day
- holding period
- day of the week
- market internals, including index direction and market volatility
Trade simulators offer the most potent approach to paper trading because they let novices set up workstations that mimic actual real-time market conditions. Many brokers now offer this service for free to customers, letting them use the same trading software as real money players. This connection is invaluable because it allows seamless transition from a simulated into an actual trading environment once the student is ready.
A final approach can be used at any time, even during weekends when the financial markets are closed. Have a friend or spouse pick a technical chart at random, print it out and hand it to you with the right side covered by a second piece of paper. Make sure the chart has all the technical indicators you want to use in real-world trading. Take the second sheet and move it to the right one price bar at a time, while you choose where to buy and sell.
Let's outline key benefits of paper trading, looking at the ways it shortens the learning curve so that novices have an advantage when it's time to play the game with real money.
- No Risk: It costs nothing, and you can't lose money with bad decisions or poor timing. It also allows you to observe all of the flaws in your analytical process so you can begin the arduous task of building a well-defined trading edge.
- No Stress: Trading evokes the twin emotions of greed and fear, often blinding participants to key information needed for effective risk management. Paper trading bypasses this emotional roller coaster, so the new participant can focus fully on the mathematical process, not the pitfalls.
- Practice: The participant gains experience in every element of the trading process, from pre-market preparation to final profit or loss taking. When accessing the broker's simulator, they learn how to use real money software in a relaxed environment, where the wrong keystroke won't trigger a financial disaster.
- Confidence: Making a series of complex decisions that gets rewarded with hypothetical profits goes a long way in building the novice's confidence so that they can do the same thing when real money is at stake.
- Statistics: Paper trading for several weeks up to a month builds useful statistics about the new strategy and market approach. The results are likely to be discouraging, forcing the next step in the new trader's educational process, in turn requiring additional paper trading and data sets.
Now let's outline the limitations of paper trading and the ways it can hurt the novice's performance, if key lessons aren't learned.
- Market Correlation: Paper trading fails to address the broad market's impact on individual securities. The majority of equities move in lockstep with major indices during periods of high correlation, which is common when the Market Volatility Index (VIX) rises. While results may look great or terrible on paper, broader conditions may have created the results, rather than the virtues or pitfalls of the individual position.
- Slippage and Commissions: Real money traders deal with all sorts of hidden costs from slippage and commissions. This is exacerbated by wide spreads that are poorly captured in most paper trading techniques. For example, the momentum stock you think you're buying on paper at $50.00 may cost you $50.50 or more in the real world.
- Emotional Reality: Paper trading doesn't address or evoke real-world emotions produced by actual profits or losses. In the real world, many traders cut profits short and let losses run because they lack market discipline. Those self-destructive calculations don't come into play when dealing with hypothetical numbers.
- Formfitting: Paper traders pick out ideal entries and exits, missing the minefield of obstacles generated by the modern computer-driven environment. These shakeout levels become all too obvious to real-world participants who have watched dozens of technically sound positions go up in flames when algorithms shift into predatory mode and seek out their stops.
The Bottom Line
Paper trading benefits new participants by letting them act out key steps in risk taking, from the selection of securities to the final exit, but the process has limited value because it underplays the impact of index correlation and emotional reactions in a typical market day. In addition, it doesn't address the impact of algorithmic strategies that routinely target the flesh-and-blood crowd.
Even so, most novices should spend a considerable amount of time paper trading their new ideas and strategies before risking real capital, gaining as much experience as possible. The exercise will pay excellent dividends, shortening the learning curve while allowing limited profitability much earlier to initiates as opposed to new participants who pass on the opportunity.