Paper Trading: Definition, Functionality, Pros & Cons

Anyone who has tried to get into asset trading would have heard of paper trading at some point. Paper trading is popular because it essentially offers investors a way to hone their skills and mitigate their risks. Notably, many major trading platforms, including eToro and MarketWatch, offer it to users alongside ‘real’ trading.

But what is paper trading in the first place? How does it work and how can it benefit you? In this guide, we’ll look into this interesting phenomenon and answer all your questions.

Paper Trade Defined

Paper trade is a simulation of a real-life trading situation, but without the risks. In a real trading situation, you would buy and sell assets at different price points, and depending on your decisions, you could make or lose money. And if you are doing this with your actual money on the line, there is a lot of risk involved.

A paper trade is essentially when a trader is given the chance to simulate trading decisions in a controlled environment without any actual assets or money on the line. In this case, the investor is given ‘virtual’ money and assets to make trading decisions with and see what the outcome would be if it were a real situation. This is used as a way to get traders familiar with the markets and hone their strategy without possibly losing their own money.

The term ‘paper trade’ was first used decades ago when, before the internet, many investors would write down the hypothetical trading decisions they would want to take. Then, monitoring the market, they would see how such a trading move would have worked out. But now, with technological advancements, many trading platforms and apps offer paper trades virtually with the same idea in mind.

How It Works

So now that you understand what paper trading is, you might want to get into it and understand how exactly it works. For anyone looking to paper trade, consider the following steps.

• Choose a platform that offers paper trade. One thing to keep in mind is that not every single trading platform or app offers paper trading to users so you have to find one that does. Also, not every platform uses the term ‘paper trading’ as some use other terms like ‘demo trading’. Either way, do your research and confirm that your platform of choice does indeed offer paper trading.
• Open a paper trade account. The next thing you’ll want to do is open an account with the platform that offers paper trade and specifically sign up for it. Many platforms will offer you a paper trade account as soon as you sign up and for others, you’ll need to search through its features to find it.
• Receive your virtual funds and features. When you receive a paper trading account, you’re usually allocated a certain amount of virtual money to play around with and given access to different trading features that mirror the real ones you would have. Familiarize yourself with the features at your disposal and decide how much of your virtual money you want to spend.
• Begin trading. Once your paper trading account is set up, you can begin making your trades. This includes buying and selling assets according to your tastes and watching market movements to figure out the right decision. As you trade, you should be monitoring how your stocks are performing and how much money you have made or lost.
• Refine your strategy. Ultimately, the goal of paper trade is to help you become a better investor. So, you have to constantly review your tactics and how they play out, change them if need be, and find your winning strategy.

Advantages of Paper Trading

Paper trading is popular because it has so many benefits to offer investors, some of which are as follows:

• The opportunity to learn. While paper trading isn’t ‘real’ trading, it does simulate trading terms of the features that can be used and the fact that the ‘assets’ gain and lose value based on the market. While you can read a million books on asset trading, there’s nothing quite like making trades to learn the ropes and this is an opportunity that paper trading affords users.
• No risk. While it is important to practice trading and refine your strategy, doing it through actual trades means that an investor might lose money. And many of them, especially newer ones, might not be able to afford multiple losses while learning. But just like training wheels help take away the risk when learning to ride a bike, so does paper trading. Because no actual money is spent, there is no risk involved.
• Less emotional stress. The risk of losing money when trading real assets is known to cause stress and anxiety for investors but paper trade takes this away, along with the possibility of losing money. This way, investors can work on their trades without the added anxiety.

Limitations of Paper Trading

While paper trading has a plethora of benefits, it also comes with its own limitations that you should be aware of.

• Lacks the emotional impact: While it is good that paper trading does not create emotional stress for users, it also means that trading decisions lack emotional impact. Taking a risky investment decision with a virtual $100 is rather easy compared to doing so with real money you had to work for. This, in turn, means that investors might not learn to weigh the impact of their decisions and could trade more recklessly in paper trading situations, which doesn’t help to build their skills.
• Builds overconfidence. In some cases, being insulated from the real-life repercussions of trading decisions could make investors overconfident in their skills and could lead them to make reckless trading decisions in real life.
• Limits expense understanding. Many paper trade applications don’t factor in other things that could lead to an investor losing money, like trading commissions and market slippage. This could lead to them being unprepared for these costs when they trade for real.

Bottom Line

The world of investing can be very intimidating and this is why paper trading is so popular and needed. With paper trading, investors (especially newer ones) can get a feel of how the market operates and how their trading decisions would pan out without actually having to risk their own money. Needless to say, paper trade comes with many benefits for investors.

At the same time, it is not without its limitations. If users rely too much on paper trading, they risk not fully grasping the impact of their decisions and could become overconfident. But if all these downsides are taken into account and managed, users can reap the full benefits of paper trading.