What is paper trading, and why it’s still important

Up until the 1960s, stock exchanges and brokerages were still run on ticker machines, which digitally communicated stock prices over telegraph lines, producing long strips of paper. It’s the waste paper from these communications that sparked the first ‘ticker tape parade’, way back in 1886.

These days, ticker tape parades still happen, but use paper shredders, toilet rolls and confetti.

Market prices are viewed digitally around the planet in real time, and there’s just not the same need for paper for traders and market makers.

So, should the idea of paper trading be retired along with ticker-tape machines?

So, what is – or was – paper trading?

Paper trading is the process of trading with pretend money, but doing it with real price levels, in real time.

It’s a great way to learn about investing, following systems, and reading technical analysis – without risking any money. You can start off with an arbitrary figure, pick the market positions your method signals, and monitor exactly what would happen to your money if you had actually taken the trades.

Old-fashioned paper trading would be done long-hand on a piece of (you guessed it!) … paper. And you’d have to check price levels at the time you’d have entered, price levels where you got out, calculating how much you’d have made or lost.

Even following your trading strategy to the letter, it would be easy to make errors.

Surely there’s a simpler way …

The modern way to paper trade is more normally called ‘demo trading’. This is an account on your brokers’ trading platform which looks just like a real, live trading account. But your broker will have already loaded the account with a few thousand pounds of pretend money.

This pretend money is there for you to practise with. You place your trades exactly as you would on a live account, and the demo account will monitor your results for you, so you’ll easily be able to see if you’re making money … or not.

Most brokers offer these demo accounts, although some don’t shout too loudly about them, or put restrictions on them. Obviously, your broker wants you to trade with real money, so they get their cut – they’re not making anything from their demo accounts.

But these demo accounts are incredibly valuable to us traders.

Demo accounts allow us to practise the processes of placing trades. We can get used to how a broker works, and find any bugs or niggles in a trading system before we’re risking real money.

They are a great environment for testing new trading strategies and judging how they’ll perform in live markets.

However, beware putting too much faith in them

The great thing about demo trading is that you aren’t risking any real money.

But that’s also its downfall. A demo account can teach you a lot of things, but it can’t show you how you’ll feel when you’ve just taken three losing trades in a row and feel like packing it in.

Nor can it teach you how you’ll feel when you’re high from a run of winners and are wanting to add more than you can afford to your trading fund.

These things can only be learned in a live trading environment.

So, is paper trading a waste of time?

There are plenty of ‘traders’ out there who’ll tell you that paper, or demo, trading is a waste of time, because nothing is learned if you’re not risking real cash.

You’ll find these kinds of comments in the testosterone-driven bars, blogs and forums, where seasoned traders talk about ‘learning the hard way’. In my opinion, it’s a lot of bravado, and no one should trade any new method without first testing it in a demo account.

But there’s another issue with demo trading that’s often ignored …

The data feed used by your broker for a demo account is not the same as the one used for a live account. Therefore, the prices will be subtly different.

Plus, demo accounts don’t suffer from slippage. Your demo trades will always be triggered, or closed at the price you’ve requested. Yet, in the real world, where prices are sometimes moving very fast, we can get in or out of trades at worse (or sometimes better) prices than we’d expected.

It’s not a huge issue, but it definitely makes a difference (normally, with live accounts coming out worse off than demo accounts), so shouldn’t be ignored.

The key to making your demo trading work

Paper trading or demo trading can be a hugely valuable testing and training ground ahead of making real money in the markets.

It can also be a complete waste of your time and efforts.

Which it is really comes down to the way you approach it.

It’s tempting with a demo account to trade off the cuff, and without discipline. It’s not real money, so it doesn’t matter if you make mistakes or don’t follow the rules. While it’s true that this behavior won’t make you poorer – it also won’t teach us anything about our trading strategy. This kind of demo trading is just teaching bad habits.

It’s also important to transition carefully from demo to live trading

Many traders assume that if their demo account is in profit, they’ll be able to make money in a live account too. They’ll then jump from pretend money to a fully loaded live account with high stakes trading.

Demo trading will allow you to develop your trading techniques and test strategies, but it can’t teach you to be a profitable trader. Move into live trading cautiously, with low stakes as you learn how you’ll cope in the real markets which can play havoc with our trading discipline and confidence.

Demo and paper trading are all about proficiency. Profitability is the next skill to be learned.

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