Advantages and Disadvantages of Paper Trading

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One of the first things that new traders look for when they become interested in the financial markets is a platform that offers a paper trading feature. Beginning traders are certainly advised to practice various aspects of trading in the markets via these types of virtual accounts. Doing so will help them save time and money and make the transition to live trading easier and more seamless.

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What Is Paper Trading?

Paper trading refers to the act of placing simulated trades in the market for the purposes of practicing and learning to trade or for testing a trading platform. Many brokerage firms offer a paper trading account which allows this type of artificial market execution.

These platforms try to maintain an environment that is as close to the real market conditions as possible. Obviously, some paper trading platforms do a better job than others in creating these conditions.

Paper trading allows novice traders to become more familiar with the process of trading and test different trading strategies without having to do so using real money. Typically paper trading accounts are funded with virtual funds that can range from $5000 to $50,000 or more. Some paper trading platforms even allow their users to set their own custom amount of virtual funds in the account.

There are both advantages and disadvantages to paper trading in the markets. We will compare and contrast these points shortly, but for now it’s important to understand that paper trading via a simulated trading platform is available through many brokers.

These include those that cater to clients in the foreign exchange market, the stock market, the options market, and the commodity futures market.

There are paper trading software programs that are available as well. These, however, often come with some cost, either one time or recurring.

As such, for most newbie traders, it would make most sense to start with a free simulated paper trading platform offered by brokerage firms.

Advantages of Paper Trading

Test Different Strategies – When you’re testing out a new strategy, it is best to paper trade it first before committing hard earned dollars behind it in the market. Doing so will allow you to better understand whether or not the strategy actually has merit and has a chance of being profitable.

As such, taking the time to test drive the strategy in a simulated account can prove to be quite useful. This is particularly true for beginning traders who are just starting out and are interested in applying a host of different market strategies in an attempt to find one or two that they feel the most comfortable with.

Sometimes, a trader will find that they cannot make consistent profits with a strategy that has a proven historical edge. One reason for this that the strategy may not be compatible with a trader’s personality. That is to say that the rules governing the trading strategy may run counter to how the trader thinks about the market, and thus they may find it very difficult to execute the rules properly and effectively.

This is where paper trading can shine, because a trader can get a sense for their comfort level with a strategy and determine whether it is suitable for their particular temperament.

Gather Performance Data – In trading, data is the name of the game. More specifically, you must know all the key metrics around your trading performance in order to improve in those areas where you may be weak. Paper trading provides a vehicle for a trader to execute a trading method in a simulated market environment, and gather important trade related metrics in the process.

Some of the more important performance metrics that traders should track include a strategy’s win percentage, average win to average loss ratio, maximum drawdown, number of consecutive losing trades, average time in a trade, and profit factor to name just a few.

Practice Execution Skills – Learning how to execute your strategy in the market is essential to your success as a trader. This is because different market environments will call for differing execution strategies. For example, within the context of a trending market, it may make more sense to use some form of momentum break out entry while in a back-and-forth oscillating market it may make more sense to use a mean reverting entry technique such as a Bollinger band extreme.

In any case, a practice trading account will allow you to apply and test various order types in the market, and hone these skills so that you can execute more seamlessly in the real trading environment.

Gain Confidence In Your Method – A paper trading account will allow you to gain more confidence in your method. This is because you can practice your set ups on a wide range of trading instruments and time frames to help speed up your learning curve. The more trades you are able to take and study, the more your confidence will grow around your preferred methodology.

For example, if you are primarily a stock trader that uses a specific chart based pattern set up on the Dow 30 stocks, you might consider expanding your universe to trading that chart pattern on all the stocks within the S&P 500. But doing so immediately in your live trading account may make you uncomfortable.

As such, you could turn to your broker’s simulated paper trading environment to execute these additional trades and see if you are able to achieve similar results. If so, then you can decide to include the S&P 500 stocks in your watchlist as well. You will feel confident doing so because you have spent the time in testing it within the simulated environment.

no-risk-paper-tradingNo Capital At Risk – One of the biggest benefits of paper trading is that you do not have to commit real capital in the market. There are a host of reasons why a trader would engage in simulated trading. It could be to test out a specific strategy, to sharpen one’s execution skill, to demo a specific platform, or to just get a handle on how trading works in general. A paper trading program allows you to interact with the markets in a simulated environment without the stress of worrying about losing your capital in the process.

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Get Comfortable With The Platform – While most traders who open a paper money trading account tend to be novice traders, this does not mean that more experienced traders cannot benefit from such activities. Traders who have been around the markets for a while have likely used some of the more popular trading platforms in the market. This includes platforms such as Tradestation, Ninjatrader, and Metatrader.

Often when traders switch from one platform to another, there is a period of time that requires getting familiar with the new platform. A paper trading account is an excellent means for getting comfortable with a new trading platform and all of the features within it. A trader can decide to move over to the live platform after gaining the needed experience with it in the simulated environment.

Disadvantages of Paper Trading

Lacks The Emotional Component – One of the biggest drawbacks to paper trading in the market is that it does not reflect the emotional highs and lows that you will go through in a real trading environment. Because by its very definition, paper trading does not represent real money, the attachment to a trade and the emotions that go along with it will be very different in a simulated environment versus a live environment. As a result, you will often act very differently when real money is on the line.

For example, if you are down 25 or 30% in your demo trading account, the stress of that drawdown may not weigh heavily on you psychologically, because in the back of your mind you realize that you have not experienced any real loss whatsoever. On the other hand, in the real world if you were down 25 to 30% in your live trading account, that knowledge would likely be a big factor in how you handle the next trade or the next series of trades.

Underestimates True Transaction Costs – Most paper trading platforms provide data based on the entry and closing prices, and does not take into account other related transactions costs such as bid ask spreads, commissions, and slippage.

These are real costs that can sometimes make the difference between a winning trading strategy and one that is just marginally profitable, if at all. As such, it’s imperative that those that use a simulated paper trading account take note of these additional cost factors and incorporate them into their overall performance metrics.

Now having said that, it’s not always easy to add these additional costs back into the strategy metrics, particularly because it’s hard to know what these exact costs amount to. One way to do this is to take an average of the bid ask spread, commission, and slippage and use that average figure as a transaction cost total for each and every trade.

Can Lead To Over Optimization – Over optimization refers to the process of curve fitting variables within a trading strategy or system in a way that appears profitable during back testing, but often results in subpar performance results in the live environment. And so, there is a fine line between valid parameter tweaking which is desirable to some extent and over optimization, which a trader should avoid at all costs.

The way that practice trading can contribute to this undesirable side effect is that during the testing process, traders unintentionally weed out certain parameters or conditions in an attempt to prove that the system or strategy is profitable. The best way to avoid this pitfall is by using an average parameter setting over a certain range, rather than a very specific parameter that best fits the back test results. This will provide for a more robust system that is more likely to produce realistic results in the real trading environment.

An example of this would be a moving average crossover signal, for example. If your entry is based on a dual moving average crossover, and you test various parameters, you may find that the best inputs based on overall profitability are the 14 and 70 period crossover. Additionally, you find that the range between 12 and 20 perform best for the shorter moving average, and the range between 30 and 80 perform best for the longer moving average.

As such, it would be better to take the average of each of the above rather than use the two best fit parameters. If we do that, we would use the input of the 16 period for the shorter term moving average, and the 55 period for the longer term moving average. This is because these inputs represent the average within the best range, rather than the best single inputs.

practice-trading-ordersDoesn’t Mimic True Execution – Another disadvantage of paper trading online is that most simulated trading platforms typically provide instant execution when a specified price is triggered. This is very different than what can happen in the real time market environment. These simulated platforms do not take into account the true bid ask spreads or the volume of order flow on either side of the market.

In real market conditions these factors can play a major role in your execution price, and whether or not your order gets executed at all. And so because of this limitation, many paper trading platforms can provide a false impression on the true nature of market execution.

Paper Trading Apps And Platforms

There are quite a few brokers that offer paper trading facilities to their clients. Let’s take some time to go over some of the more prominent paper trading platforms offered by brokerage firms.

Paper Trading Forex

eToro – eToro is a popular social trading platform. They offer a virtual trading account and a real trading account within a singular dashboard. Traders can toggle between their demo account and live account with a single click of the mouse. Within eToro, traders can access a huge number of trading instruments including all major and minor Forex pairs, crypto currencies, and more.

One of the unique features within the eToro trading platform is its copy trading technology. Traders can copy trades from other users on the platform and even build a portfolio of copy trading strategies. Overall eToro is considered the best forex paper trading platform around.

FXTM – FXTM is a major foreign exchange broker that is regulated by the Financial Conduct Authority in the United Kingdom. It is a very well respected broker that offers ECN based pricing. As such, their bid ask spreads are among the lowest in the industry. They offer both a free paper trading account and a real live account, of course.

Traders can access over 50 different currency pairs including the majors, minors, and other exotic pairs. In addition, they offer micro lot trading which allows even those individuals with the smallest of accounts to make the switch from paper trading to live trading as effortless as possible.

Paper Trading Stocks

Webull – Webull is a new player in the stock brokerage industry, but it is becoming one of the fastest growing in the industry. They offer an excellent stock paper trading platform that allocates up to $1 million to a virtual trading account. Traders can test out their strategies and get acquainted with the platform in case they decide to open a live account at some later point. Webull offers zero commissions on trades and there is no minimum for opening up an account.

E-Trade – E-Trade is an established stockbroker that has been in the business for many years. It’s a well-known name in the industry. They only offer a paper trading account to current clients. So you will need to have an existing account that is funded in order to take advantage of their paper trading platform. Both the paper trading platform and the live trading platform can be accessed from a single dashboard, and traders can toggle between the two as needed.

Paper Trading Options

ThinkorSwim – ThinkorSwim is the industry leader when it comes to options trading technology and platform capabilities. ThinkorSwim falls under the umbrella of TD Ameritrade. They offer the most sophisticated trading tools for option traders. They offer two different types of paper trading accounts. The first is a traditional margin account, while the other is an investment retirement account, IRA.

The TOS trading platform is available for free to any interested persons, however, they will set a time limit of 90 days for the paper trading account. After which, users will need to sign up for a live account which can be funded with any amount. Once a user is signed up for a live account, they will continue to have access to the practice account as well.

EOption – Eoption is a discount brokerage firm specializing in options trading. They offer a paper trading account called Paper Trader, wherein you can get $100,000 in a virtual account to trade stocks and options. For those who are interested in opening an account, Eoption offers a minimum account opening of $500, which is fairly nominal compared to others in the industry. Their trading platform, while not as sophisticated as the ThinkorSwim platform, does offer most of the tools required to make informed decisions around options and equity trades.

Paper Trading Futures

Tradestation – Tradestation is one of the oldest and most well respected trading platforms and brokers in the industry. They offer a full set of professional features within their trading platform including a back testing and optimization engine. Tradestation provides access to a wide range of markets, however, they are most popular with commodity and futures traders.

Tradestation offers many resources outside the traditional set of tools offered by other brokerage firms. This includes a fully functional paper trading platform, along with educational products, and an extensive set of technical trading tools.

Interactive Brokers – Interactive Brokers is best suited for experienced and professional traders. They offer a paper trading platform along with their live Trader Workstation platform. The paper trading platform is funded with $1 million in cash, and it can be tweaked to meet your specific virtual capital preferences.

Interactive brokers offers a massive number of trading instruments. This includes access to domestic and international equities markets, fixed income products, futures market products, options markets, and more. If you looking for a global futures paper trading platform, then IB may be the right fit.

Download the short printable PDF version summarizing the key points of this lesson…. Click Here To Download

Closing Thoughts

As we have seen, paper trading offers many benefits to both novice and experienced traders alike. Having said that, you must also realize that there are certain drawbacks that are inherent with paper trading the markets. So long as you are aware of these deficiencies, and address them accordingly, the benefits of paper trading far outweigh the drawbacks.

We have listed a few of the major brokerage firms that offer free paper trading capabilities within their respective market categories. Although this is not to be considered a full or all-encompassing list, it should serve as a good reference point from which to start doing your own research in this area.

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