Paper Trading: How It Works

Paper Trading: How It Works

Reading time: 8 minutes

What is Paper Trading?

Paper trading boasts a long and colourful history. Prior to the introduction of online trading platforms, aspiring traders would jot down their trades on ‘paper’ at the price levels they wished to buy and sell from and assess performance based on this. Paper trading, or ‘demo trading’, has come a long way since then. Today, traders can access online virtual trading environments – think of it as a simulated trading platform — in which they can practice trading in financial markets and improve their trading skills and decision-making void of financial risk. The ultimate aim of paper trading is to assess a trading system’s performance, explore trading platforms and gain experience. This is why it is often recommended that new traders use a demo account before beginning live trading with real money. This can be done in any market – Currencies (Forex), Commodities, the Stock Market and even Digital Currencies – and across any timeframe.

Paper Trading Vs Backtesting:

• Paper trading involves simulating real-time market conditions using virtual money – this is forward testing a trading strategy. Engaging in paper trading through a demo account helps a trader become familiar with the trading platforms and acquire the skills to execute trades in real time by utilising a strategy that has been previously tested: backtesting.
• Backtesting a trading strategy evaluates a strategy's performance based on previous price data by applying buy-and-sell criteria, permitting traders to assess the strategy's performance using previous price action. Backtesting is conducted on a demo account and can be carried out on any chart/market that displays historical market data. It is a valuable tool for improving strategies since it allows for the simulation of several trades based on past price movements. However, it is important to be aware of curve fitting when using in-sample data; that is, adjusting your trading system to suit price data. As you can imagine, this is unlikely to perform well when tested using out-of-sample data: price data the strategy has not been tested on. 

How Does Paper Trading Work?

Successful trading (and investing) require a unique skill set. Working with a clear trading system is one such skill necessary to achieve consistent performance. One achieves this by first studying two of the main research methods used to trade: technical analysis and fundamental analysis. Subsequently, following an understanding of how to research the markets, the trader must devise trading ideas that are testable, and this is where paper trading and backtesting steps into the fray. It is here that you can employ a simulated demo trading account to test drive your trading ideas, essentially helping to validate them before moving to a live trading scenario. 

At its core, a demo account opens the door to the financial markets. It allows you to familiarise yourself with the different markets to trade, order types (think market orders, protective stop-loss orders and pending orders, for example), analysis tools, and, as briefly alluded to above, permits you to trade the markets without the need to deposit live funds. Think of it as your training, similar to when learning to drive a car. You need to practice before achieving sufficient competence.

Pros and Cons of Paper Trading

Many professional traders recommend the use of demo accounts. In fact, even professional traders use demo accounts to validate new ideas before moving to real market conditions. 

We all make mistakes, but the more experienced one becomes, the fewer mistakes there should be. Trading in the financial markets, particularly for beginner traders, involves many mistakes, and these are better suited to a demo account. However, like everything in trading (and in life), there are pros and cons to paper trading.  

Pros -

• One of the most obvious benefits of paper trading provides is that it does not involve funded accounts. Regardless of the trading decisions made, demo trading offers a risk-free simulated trading account, allowing you to begin your trading journey to learn and grow.
• A paper trading account allows the trader or investor to familiarise themselves with the trading platform’s functionality, including understanding the order types offered, how to place an order on the platform and the markets offered. 
• Paper trading builds much-needed confidence in your trading strategies and approach to risk and money management. The benefit of having paper trading statistics to hand before trading live is priceless. If you overlook demo trading, you are entering a live market trading scenario almost blind. With demo statistics, you will know the average risk/reward ratio, the maximum drawdown, the win rate as well as consecutive winning/losing trades. Therefore, when you do eventually move to live trading, consecutive losing trades will not be a surprise, as you have seen this situation before. 

Cons -

• Many traders note a common disadvantage: the lack of emotional influences in demo trading. With live trading, capital is at risk, which makes emotions inherently different from paper trading.
• Paper trading can distort the true cost of trading as the cost of slippage and commission will unlikely reflect live trading conditions.

Open a Demo Trading Account with FP Markets Today

The importance of using a demo account to validate trading ideas is an understatement. At FP Markets, we understand the need for trading simulation applications.  

Fortunately, FP Markets has a number of world-class trading platforms that offer paper trading platforms, including MetaTrader and cTrader. You may also enable paper trading by logging into your FP Markets TradingView account and navigating to the trading panel at the bottom (see image below). Activate the ‘paper trading’ button on the far left side. After that, you will need to reset your account balance as close as possible to your real-life trading balance; in the gear menu on the right-side panel, click ‘reset paper trading account’ and enter a new account balance.

Paper Trading FAQs

1. Why Is Paper Trading Important?

With paper trading, you can assess the performance of your trading systems in a risk-free environment and familiarise yourself with the platform’s features. 

2. Who Can Benefit from Paper Trading?

Paper trading is a useful tool for new traders developing new strategies and test-driving new trading platforms.

3. How Can You Get the Most from Paper Trading?

To get the most out of paper trading, you must treat it like a real-world trading account with real money. Trades and performance should be recorded in a trading journal. It goes without saying that you should also work from a well-defined trading plan with clear entry and exit signals and a solid risk management strategy to get the most out of your trading experience and produce as accurate results as possible. 

4. How Can Paper Trading Help Professional Traders?

Experienced traders use demo accounts to test the validity of new trading systems that they have developed. They also tend to employ the use of a demo account when they are looking to start trading on a new trading platform.