Paper trading has its place in the trading learning curve, but it is not at all a substitute for live trading with real money. The reasons why should be fairly obvious. Paper trading has no monetary risk attached to it, so it does not evoke any emotional reaction to the outcome. If you don’t agree, try paper trading where you agree to give the amount of any loss to someone you don’t get along with, should your trade go the wrong way!
The Value of Paper Trading
What paper trading is good for is learning to use a trading platform and understanding the mechanical process of placing a trade. This should be done in a broking account, or at the very least in a spreadsheet. If your choice of online broker does not offer a sandbox facility, consider finding one that does.
The usefulness of paper trading lies in experiencing the time and energy it takes to complete your daily trading process. However, because it’s paper trading, the tendency will be to spend less time paper trading than you would live trading. Another use is to test your strategy for profitability and trade frequency.
Setting Realistic Expectations
Many traders who are just starting out make the mistake of deciding not to trade in the future because, after months of learning, they see their first three or four trades not perform well in paper trading. To get a realistic indication of how a strategy is performing requires at least fifty trades over several market scenarios.
Market scenarios are the ups and downs of the market as it swings over time. Any trader needs to be aware of the mood of the market and time their trades accordingly. Experienced traders may well place long and short trades whenever the opportunity arises. However, as a beginner, short trading is not advisable. Remember, short trading involves selling shares that you effectively borrow from a broker in anticipation of the price falling lower. Then, you buy the share back and make a profit. Price swings to the downside tend to be short and sharp, while upward moves are typically slower and longer. This means catching a short trade requires more skill.
Integrating Paper Trading with Backtesting
Paper trading is often completed in conjunction with a backtest. See our article on backtesting for more on that topic. Regardless, paper trades need to be recorded and analyzed as if they were real trades. Don’t fall into the trap of dismissing a loss on the basis that “I would not have taken that trade in the real world anyway.” This error is common and should be avoided. We humans love to rationalize, but the market will not abide by our wishful thinking.
Challenges of Sandbox Accounts
Another issue with paper trading is the realism of sandbox accounts. These accounts usually don’t have enough market depth to be realistic. Market depth is the list of buyers and sellers in the market that you would compete with for buys and sells. The market auction in a live market is dynamic and can be volatile. Most sandbox accounts don’t give the feel of a live market.
Collaborative Paper Trading
Paper trading is best completed with a friend. Having someone ask you to explain what you are doing will consolidate your knowledge of your own strategy. This leads to never, never bending or breaking your strategy rules. This is critical to getting an accurate result. If a strategy is not profitable, complete the testing that was planned, then move on to a revised strategy.
Because trading profitability can be the result of a couple of big wins at any time during the test period, it is vital to finish the test. If for no other reason than it can then be compared to other tests.
Paper Trading as a Serious Endeavor
Paper trading can induce a false sense of “fun.” Trading should be enjoyable, but not entertainment. It is a business, and a business has KPIs to meet. Make sure you know what your goals are and assess each trading strategy against those goals.
It is all too easy to massage paper trading to make us feel good, but then live trading may just bite, and you don’t want to risk capital on a strategy that has not been adequately tested.
Conclusion
Don’t forget, a large part of a trading strategy or plan is knowing that it is profitable before committing real funds. This will help to control the emotional content of trading with real money.
