Paper Trading

What is paper trading?

Paper trading is the method of practicing trading in a virtual environment without investing money literally in the stock market. Concrete trading will take place in a simulated environment where real-time financial data (values and price moments of stocks)  will be pulled to create a virtual reality that will not affect the stock market.  

The term “paper trade” came forth when, in a period where there was no electronic trading, the trading strategies, ideas, and actions were practiced on paper manually. This allowed traders to compare their actions and strategies with the actual stock movements to check accuracy and efficiency after every trading session.

Now, paper trading is conducted over trading platforms that use predictive analytics and risk management solutions to simulate investment and deal scenarios using data aggregation from different places.

Types of paper trading

In actuality, there are no different types of paper trading. The terms simulated or virtual trading refer to the same concept. However, different platforms, tools, and methods are used in paper trading, which differentiates each one from another. Some of the popular ones are:

• Spreadsheet-based paper trading: This is a low-tech paper trading method where spreadsheets are used to monitor trades and strategies manually. The input would consist of buy and sell transactions and calculating profits and losses, which helps them track portfolio performance.
• Algorithmic paper trading: Engaging in algorithmic paper trading involves refining and training an algorithm to automate paper trading and its strategies in a simulated environment. This allows traders to predict the results of every strategy and trade for various situations, transactions, conditions, prices, and values in the market.
• Backtesting: The application of a paper trading strategy to historical market data to evaluate a hypothesis is known as backtesting. This helps in predicting potential market changes based on past performance in the market, provided conditions remain unchanged.

In addition to these methods of paper trading, there are various other kinds differentiated based on the tools used. These include electronic paper trading, such as online trading simulators and mobile app simulators, that can be standalone, brokerage-based, or game-like stock market simulators and manual paper trading.

Benefits of using paper trading

Paper trading frames real-time trading and situations to create potential strategies and transactions and calculate risks to eliminate future losses. Its benefits include:

• Practicing trade strategies: In line with the old saying, “practice makes one perfect”, repeated exercise of various trading strategies will help traders understand current market conditions. It is also helpful for a trader who is just starting out to practice with fake money in actual market conditions to gain experience.
• Eliminate risks: Through practice trading, a trader can eliminate potential risks by simulating the dynamics of the market and forecasting returns. This will aid an investor in understanding their shortcomings and build a strong real-time portfolio.
• Educational purposes: Game-like stock market simulators are used by educational institutions and traders to educate new traders about established strategies and techniques. It is also useful to increase familiarity, shorten learning curves, and gain financial knowledge of current trends and market volatility.

Challenges of using paper trading

Even though the benefits surpass the loopholes of paper trading, these risks should not be ignored. The limitations and drawbacks associated with paper trading are:

• Lack of psychological impact: There are no emotional jolts when one uses fake or virtual money while making hypothetical investments. Therefore, traders make extreme choices in simulations that they would not have made if it was in real-life situations. This results in overconfidence regarding success among traders and bullish investors diving into the market, which might have a negative effect.
• Does not account for costs: These simulations do not account for other costs of trading, such as brokerage commissions, transaction fees, tax accounting, and additional hidden costs. Therefore, paying attention to these slippages may result in the right calculation of returns. 
• Delayed data: Many paper trading software need help pulling real-time data and aggregating other financial data from the market, which causes discrepancies in calculating trade transactions. The consequences are erroneous profit and losses.
• Formfitting: Paper trading outcomes are usually ideal entries and exits. This means that a plethora of minefields may be ignored and missed. When established and technically sound positions face failures in real-time trading, participants or traders may face a critical setback.

Basic elements of paper trading

The process of paper trading involves the simulation of live trading exercises in a virtual environment like buying and selling financial instruments using virtual money. Therefore, the process of paper trading should include the following elements:

• Simulated trading platform: The standard method of paper trading is currently via electronic means. Therefore, access to an artificial computerized simulation allows users to execute orders and trades using virtual money.
• Real market data aggregation capability: Real-time data must be pulled from various data sources for simulating actual market conditions, such as value, prices, volume, spreads, and other stock information. Therefore, it is important for paper trading software to have data integration capabilities.
• Portfolio management: A tailored dashboard to manage bespoke portfolios is required with capabilities such as financial analytics, risk management, charting, order tracking, and other trading tools for efficient paper trading and practice. 
• Learning and education: Various asset types, investment methods, and trading processes must be given access via the paper trading platform to educate traders and new users regarding live trading practices.

Paper trading best practices

• Treat it like actual trade: A trader should not conduct extreme trades that one would not run if it were real circumstances. This will help the trader have a stern psychological balance of transactions and build good habits for managing risk.
• Track, record, and review trades: Every trade must be monitored and the progress must be charted. Reviewing the trade transactions and recording the ups and downs eases the learning curve.
• Choose the right platform: As paper trading via electronic mode becomes more common, selecting an efficient platform to conduct trade simulations that has real-time data aggregation and analytics capabilities plays an important role. Depending on the learning curve a trader is in, they must choose the complexity of the platform that best suits their practice and range of trading options.

Paper trading vs. demo trading vs. live trading

Virtual trading is another term used for paper trading, which refers to trading stocks, forex, or futures without risking real money.

Demo trading refers to an often interchangeable and related topic of paper trading where platform access is provided to a user to practice trading, transactions, and strategies to get used to the software before the trader commits to investing real money in platform subscriptions or licenses as well as in trading.

On the other hand, live trading involves actual risk, real money, and potential returns. It is a process of trading in the stock market in real time. Therefore, to succeed in live trading, sound judgment, market knowledge, and strong emotional balance are required as traders exhibit differential behavior in comparison to paper trading.

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