So you've racked up thousands of dollars in paper profits on your favorite stock simulator and are now ready to take the big step from virtual trading to the real thing? Lest you think that making the transition will be an easy process, be aware that trading in the real world is an entirely different ballgame from simulated trading. Below are five disadvantages of stock simulators.
- If you've come up with a new trading strategy or market model, a good idea is to back-test it using simulated trading and paper profits or losses.
- While there is great advantage to simulation, there are also several pitfalls that traders should be aware of.
- Over-reliance on the model, the lure of complexity, and the lack of market psychology in simulated data are all potential downsides.
1. Simulated Trading May Breed Complacency
Perhaps the biggest danger of a stock simulator is that it may lull a novice trader into a false sense of complacency if they have had a hot streak of several successful virtual trades. As any trader will attest, real-life trading poses several challenges – some of which are detailed below – that are not part of the virtual trading environment. As a result, trading outcomes in the real world can differ very significantly from the results of simulated trading.
2. Unrealistic Trades
Stock simulators have become increasingly sophisticated in terms of their offerings, and a number of them come close to replicating the real-life experience of trading. But most simulators do not offer a real-time trading environment with live prices. This can be a significant handicap, as trading decisions made on the basis of live prices can be markedly different from those made with the benefit of a 15-20 minute lag that is a common feature in simulated stock trading programs.
The prices obtained for opening and closing positions in a stock simulator may also be quite different from those obtained in the real world. For instance, there may only be 500 shares of a stock offered at $10 in the market. But if the virtual trader puts in an order for 5,000 shares in a stock simulator, they may get "filled" at the current price of $10 for all 5,000 shares of the virtual order, despite only a tenth of the shares being offered at that price.
3. Risky Strategies
Since there is no actual capital at stake, a stock simulator may foster excessive risk-taking and form trading habits that become difficult to shake off in the real world. Strategies like short sales, momentum trading and the use of leverage need a certain degree of expertise because of their higher degree of risk. These strategies may appear easier in the simulated stock environment than they are in the real world.
4. Other Factors Not Considered
There are numerous factors that affect trading and investment decisions, such as one's risk tolerance, investment horizon, investment objectives, taxation issues, the need for diversification, and so on. Stock simulators may not take all these factors into consideration. The introduction of such constraints in the real world means that investing or trading results may be very different from simulated results.
5. Investing Psychology Not Taken Into Account
This is perhaps the biggest drawback of stock simulators, in that it is impossible to take investor psychology into account because actual hard cash is not at risk. One of the fundamental principles for trading success is cutting losses and letting winners run. While it is easy to adhere to this principle in simulated trading, it is an altogether different matter in the real world, where the general tendency is to do the exact opposite. This is because most investors hang on to a losing position in the hope that it will eventually come back to break even or a profit since it is psychologically difficult to accept a loss.
The temptation to take profits early is also hard to resist in the real world, for fear that a winning position could turn into a losing one. Investor psychology is a very potent factor that separates successful traders and investors from those who are not as successful. This cannot be reproduced in a stock simulator.
The Bottom Line
Stock simulators enable one to practice trading without putting any actual capital at risk and in an environment that is quite close to the real world. But they also have a number of disadvantages that you should be fully aware of, before making the transition to actual trading.