Paper trading: advantages and how to

What is paper trading?

Paper trading is the practice of simulating trades in live markets without actually buying and selling securities. It’s a way to manually test and track trading strategies without risking capital on open trades.

The name paper trading originated before the digital era. Without the use of demo accounts and other trading simulators, traders applied their strategies to the market by hand. Traders would note how their proposed trade would perform in the live market by hand, tracking profits and losses made. While there are now tons of digital options for testing trading strategies, the name paper trading has stuck.

Whatever form you paper trade in, it's useful to test your trading strategies before trading live markets where real money is at stake.

What are the advantages of paper trading?

Paper trading offers several advantages for new traders compared to immediately trading live markets:

·      You can test new strategies before risking money in a live account

·      Paper trading forces you study and understand market effects, helping you become more knowledgeable about the markets you want to trade

·      A physical ledger of your trades allows you to reflect and analyse on past actions and your own trading psychology

Paper trading vs live trading

Paper trading attempts to mimic live trading as closely as possible. Paper trading may give you more accurate test results compared to other methods of evaluation like backtesting. However, there is one major disadvantage. When trading in any type of simulated account, your emotional response will not be as strong as when trading live markets.

The psychology behind managing your emotions when trading is one of the largest risks new traders have to manage. Impulsive responses to market movement can completely deride your planned strategies. Paper trading in simulated accounts with no capital risk can give you a false sense of confidence while trading. Not using real money may also numb your reaction to losing trades.

In this regard, there is no substitute for live trading. However, paper trading with a demo account before hitting live markets is strongly advised. Learn more on how to trade successfully, then open a demo account to paper trade yourself.

Paper trading vs backtesting

While paper trading evaluates how your trading strategy performs in real-time, backtesting applies your strategy to past markets. Backtesting a trading strategy can be done manually or with automated software. The process involves identifying moments in the past when your trading strategy would be triggered. Then, you open a position and follow the trade to its conclusion.

Backtesting allows you to evaluate multiple results of your trading strategy in a given period simultaneously. You can then calculate a percent return for the total period analysed, providing a clear picture of how profitable your strategy may be.

Unlike paper testing, backtesting is done in historical markets. This comes with some disadvantages. Market conditions could have shifted dramatically enough that there is no suitable period to backtest your strategy in.

Additionally, backtesting can only be done with technical strategies. Entry and exit points must be triggered by price action and indicators to accurately predict past performance. Paper trading, in comparison, can involve fundamental analysis as you monitor your trading strategy in real-time.

Paper trading simulators

Most trading platforms offer paper trading simulators, usually advertised as demo accounts. They may vary by provider, though. Some online brokerages offer demo accounts with delayed market information. Other less sophisticated trading simulators may display completely random market action not connected to the real markets.

How to start paper trading

You can start paper trading in just a few minutes with a City Index demo account. The demo account provides access to all 13,500+ markets available to live accounts with unlimited features like TradingView, Trading Central analysis and more. Open a demo account today and practise trading with €10,000 in virtual funds. Then, when you’re ready, open a live account to bring your trading strategy to the markets.