What Is a Paper Trade? Definition, Meaning, and How to Trade

What Is a Paper Trade?

A paper trade is a simulated trade that allows an investor to practice buying and selling without risking real money. The term paper trade dates back to a time when aspiring traders practiced trading on paper before risking money in live markets—well before online trading platforms became the norm. While learning, a paper trader records all trades by hand to keep track of hypothetical trading positions, portfolios, and profits or losses. Most practice trading now involves the use of an electronic stock market simulator, which looks and feels like an actual trading platform.

How Paper Trades Work

As the name implies, paper trading is the term that the investment industry uses to describe the process of learning how to trade. It allows day traders and other individuals, such as new and novice investors, to learn the basics of buying and selling stocks without using real money. In essence, paper trading is a type of trading simulator that is done on paper.

To get the most benefits from paper trading, investment decisions and placing trades should follow real trading practices and objectives. The paper investor should consider the same risk-return objectives, investment constraints, and trading horizon as they would use with a live account. For example, it would make little sense for a risk-averse long-term investor to practice numerous short-term trades like a day trader.

Paper transactions can be applied to many market conditions. For instance, a trade placed in a market characterized by high levels of market volatility is likely to result in higher slippage costs due to wider spreads compared to a market that is moving in an orderly manner. Slippage occurs when a trader obtains a different price than expected from the time the trade is initiated to the time the trade is made.

Investors and traders can use simulated trading to familiarize themselves with various order types such as stop-loss, limit orders, and market orders. Charts, quotes, and news feeds are available on many platforms as well.

Special Considerations

The development of online trading platforms and trading software increased the ease and popularity of paper trading. Today's simulators allow investors to trade live markets without committing actual capital, and the process can help individuals gauge whether their investment ideas have merit. Online brokers such as TradeStation, Fidelity and TD Ameritrade's thinkorswim, offer clients paper trading simulators.

For example, TD Ameritrade's paperMoney® is designed to help customers try options and different investment strategies without the worry of losing any money. Nearly everything about the simulator is the same as their feature-rich thinkorswim trading platform, except the investor is not trading real money. Investopedia provides a free simulator for trading stocks.

Advantages and Disadvantages of Paper Trading

Advantages

The main benefit of paper trading is that it eliminates the risk of loss. That's because paper trading involves the use of so-called paper or fake money. As such, you don't have to use (your own) real money to trade stocks or other securities.

Paper trading allows you to study and test different trading strategies and techniques before you go live with the real thing. You can familiarize yourself and practice with as many tools as possible and decide which ones make the most sense for you, your comfort level, and your goals.

Disadvantages

Paper trading isn't perfect as it doesn't involve the use of real securities. As such, it may provide a false sense of security and often results in distorted investment returns. In other words, nonconformity with the real market happens because paper trading does not involve the risk of real genuine capital.

Since there is no risk of loss with paper trading, there is also no potential for a return. If a trader makes a good move using a paper trade, there's no chance that they'll be able to realize the gain because they aren't using real money.

Paper trading allows for basic investment strategies, such as buying low and selling high, which are more challenging to adhere to in real life, but are relatively easy to achieve while paper trading.

Paper Trading vs. Live Trading

Paper and live trading allow investors to make decisions on their own—without having to consult with an investment professional, such as a broker or dealer. This allows them to make judgments and come to their own conclusion about trends in the market.

But there are key differences between the two that set them apart. The most obvious difference is that paper trading doesn't come with the risks and rewards that come with buying and selling assets with real money. Traders can stand to lose and profit from using live accounts compared to using paper trading.

Having said that, live trading requires traders to have some grasp and knowledge of how the markets work in order to be successful. This allows them to find ways to minimize any losses that may arise as a result of mistakes. And if any losses do occur, they may have the ability to recover quickly without sinking even further.

Keep in mind, though that investors may exhibit different emotions and judgments when risking real money. This can lead them to different behavior when operating a live account. Consider a real trade by a new forex trader who enters a long position with the euro against the U.S. dollar ahead of nonfarm payroll data. If the report is much better than expected and the euro drops sharply, then the trader may double down in an attempt to recoup losses in a paper trade, as opposed to taking the loss as would be advisable in a real trade.

The Bottom Line

Trading can be very risky as the potential for loss is huge. But the same can be said about the possibility of making big returns. One way to help mitigate losses while raising the potential for gains is to try paper trading. This form of stock simulation allows you to test out and practice how to buy and sell stocks without putting up any capital before you do so in real life using a real account. In order for it to work, you must be realistic. Buy and sell the stocks you would in real life using the same amount of capital you'd deposit into a real account.