What is the 'Paper Trade'?

A paper trade is simulated trading that allows investors to practice buying and selling securities without risking real money. 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 with 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 increased the ease and popularity of paper trading without the commitment of actual capital. Another benefit of a paper trade is that it can be used to test a new investment strategy before employing it in a live account. To derive the most benefit from paper trading, investment decisions and trades should be based on the same risk-return objectives, investment constraints and trading horizon as one would use with a live account. For example, it would make little sense for a risk-averse investor to paper trade in the same way as 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 for paper trading.

Paper Trade to Test Order Types and Market Conditions

Investors and traders who wish to paper trade should familiarize themselves with various order types such as stop-loss, limit and market. A paper should occur 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 and often resulting in distorted investment returns. This is because paper trading does not involve the risk of real genuine capital, and basic investment strategies such as buying low and selling high, which are difficult to adhere to in real life, are relatively easy to achieve while paper trading.

Paper Trade Psychology

Investors and traders are likely to exhibit different emotions and judgment when risking real money that may cause them to act irrationally when operating a live account. For example, consider a real trade by a new foreign exchange trader who enters a long position with the euro against the U.S. dollar ahead of nonfarm payrolls data. If the data are much better than expected and the euro drops sharply, the trader may double down in an attempt to recoup losses as opposed to taking the loss if it was a paper trade because no real capital was lost.

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