Did you know that many school districts in the United States offer economics courses, in which students manage a “demo” stock account and must monitor the progress of their investments over the semester? These accounts were introduced in order to teach students the basics of investing in the stock market.
To my knowledge, there is nothing similar in French schools. Therefore, we must take our stock market training into our own hands. Paper Trading (in French: “simulated trading”) could be the appropriate solution.
The key steps
To become a successful investor, whether with stocks or options, you will not escape the implementation of a structured plan to introduce you to the stock market. In addition, in my opinion, four steps are important to acquire the necessary knowledge and experience. A training schedule could for example be broken down as follows:
- Learning stage number 1: reading specialized works and internet research
- Learning step number 2: experimenting with Paper Trading
- Learning step number 3: Real trading with small investments
- Learning step number 4: Real trading with higher investments
If, for example, for options trading, you start directly with step 4, without having previously read a few books dealing with options and without having tested strategies with fictitious money, the path to becoming a pro and leading to profit will be fraught with pitfalls and costly.
Today we focus on learning step number 2: experimenting with Paper Trading . What is Paper Trading and what are its advantages and disadvantages?
What is Paper Trading or “simulated trading”?
Paper Trading is a simulated transaction, through which you can practice buying and reselling securities (stocks or options), without involving real money. You can trade to simulate and track hypothetical investment positions as well as the entire portfolio. Paper Trading usually includes the use of an account, called a demo account, with a platform for simulating trades, which looks and feels like a real trading platform in every way. The spread of such trading platforms has improved the ease of access and popularity of Paper Trading .
What is a demo account?
A demo account is a form of account offered by LYNX allowing you to test the ease of use as well as the functions of the TWS trading platform, before you invest your own money for trading. You pay no commission for Paper Trading in a demo account.
With this demo account, you have the opportunity to trade options and test different strategies, without losing money.
The 5 advantages of Paper Trading
Here, let’s review the benefits you can reap from Paper Trading.
- There is no risk for your money . With Paper Trading, you can try everything, invest in the most exotic stocks and try the most complex combinations of options. No matter if you made mistakes, you won’t lose money and pay no tax.
- You can trade stress-free . With Paper Trading , you can make decisions with a cool head. Emotions will not cloud your judgment. Fear and greed, emotions that both play an important role in investor failure, will not be relevant.
- You learn how to use the trading platform . Imagine a pilot having to transport 250 passengers. Seating the pilot in his cockpit and making him make his first real flight from Paris to New Delhi, after having read only a few books on aviation, is an idea that would not occur to anyone. He will first train for hours in a simulator and have to accumulate experience.
The simulation platform is as important for you investors as the flight simulator for a future pilot. In a real platform, it can be dangerous to press the wrong buttons. If you confuse “buy” and “sell”, your take-off in the world of the stock market could be very chaotic.
- You develop your self-confidence . When you successfully complete trades in your demo account, you gain confidence. Without the preliminary test in a demo account, you would probably not be ready to open the corresponding trades in the real trading environment. What’s more, if you want to test new investment categories, to which you are not yet seasoned, then the demo account is the ideal place for you to practice.
If, for example, you have experience in stock trading, but want to experiment with new investment categories, then Paper Trading is for you. Let’s say you want to trade options, futures, commodities or currencies for the first time. These markets are subject to other influences than those of equities. Order types and margin requirements may also differ from those for stocks.
- You improve your trading strategy . In your demo account, you can give free rein to your ingenuity. Test strategies, evaluate your success rate as well as your potential gain and loss, optimize them and brainstorm until you get a strategy that allows you to apply it with real money. This experimentation with a strategy is a form of backtesting .
Backtesting is a common method to see if a trading strategy or pattern would have produced good results in retrospect. With Backtesting, a trader can simulate a strategy by using historical data to generate hypothetical results and analyze risk and return, before risking their capital. Backtesting can be an important step in optimizing your trading strategy.
With Paper Trading , you should consider the same return and risk objectives, the same investment limits, and the same horizons in terms of the duration of trades as if you were applying them in a real account. For example, it would make little sense for a risk-averse investor to act in simulated trading as a daytrader , if their real plan is to invest for the long term.
The 5 Disadvantages of Paper Trading
Paper Trading also comes with some disadvantages, which should be mentioned:
- Market conditions are different . With Paper Trading, your trades will always be executed. It is not at all certain that the execution conditions in the real platform are identical to those of the simulated trading.
If the success of your strategy depends on obtaining 2 or 3 cents more per trade, then Paper Trading will not be able to bring you the results allowing you to validate this strategy. Discrepancies between the execution patterns in the demo account and in the real account will be present and may distort the final trading result.
- Paper trading does not improve your emotional control . Among the advantages that Paper Trading contains, there was the fact of being able to invest without stress in a demo account. In simulated trading, fear and greed are simply neutralized. But when you connect to your real deposit, another wind will blow, against which Paper Trading cannot truly prepare you.
When risking their own money, investors tend to show their feelings and emotions, which can lead to irrational behavior when trading in a real account.
While you might be able to let a position’s gains run in a demo account, in a live account you might want to pocket those gains in a hurry, lest you eventually let them slip away. When the going gets tough and the occasional big loss pops up, it won’t always be easy to keep a cool head because you know your hard-earned money is now on the line.
- Paper trades have no effect on the market . In your demo account, your trades have no effect on the price of the underlying asset you are trading. In the real investment, it is not excluded that your investment volume has an influence on the prices, especially with stocks with low volume. This is why Paper Trading is not suitable for simulated trading of Penny Stocks or stocks with low liquidity.
- Transaction fees will not always be taken into account. When you invest a lot, transaction fees can play a role in your overall performance. When the demo account does not take these fees into account, the final result may be distorted.
- You might let your guard down . Sometimes in a demo account any trade will be placed because it costs nothing. Good trades are mixed with mediocre trades, without you particularly worrying about it. If this attitude carries over to your actual trading, it will be a source of inconvenience for you. This is why it is advisable to adopt from simulated trading an investment discipline and to ensure the quality of the trades that will be carried out.
Should You Practice Paper Trading ? Yes, if you have just started on the stock exchange, if you are starting to discover a trading platform or if you want to test new strategies.
Paper Trading is an excellent method to familiarize yourself with a trading platform. You can also test new strategies here without risk, before taking the plunge and placing trades with real money.
Paper trading can also give beginners the impression that the stock market is relatively simple. In practice, this can provide a false sense of security and lead to skewed returns on investment.
You will only be able to truly master your emotions after investing your own money. You have to risk real money in order to gain real experience. If you only do Paper Trading for two years, without making an investment in a real trade, you are slowing down your personal development.
However, it is not a question of investing all your assets in one piece. Positioning with little risk and minimal investment sums is a good start. You will certainly not earn a lot of money when you start out, but you will gradually become an ever more knowledgeable trader. This is the next training step after Paper Trading.