What is Paper Trading? What are its pros & cons?

Securities trading has been growing in popularity in Nigeria and around the world.

The start of the coronavirus pandemic caused young people from around the world to look for opportunities in financial markets.

There has been growing interest in retail trading with small investors seeing it as a way to grow their income and savings.

Worldwide retail brokers targeting small individual investors like Robinhood, IG, Plus500 have reported 300-400% growth in their trading volume during March 2020 to June 2021 period. Major Market indices and securities have seen appreciation in value due to this bullish demand from retail investors.

Retail trading has been greatly popularized by retail brokers in respective countries like Robinhood, E-Trade, Webull in US; Angel, Zerodha, Upstox, Groww in India; Easy Equities in South Africa; Cowrywise, Bamboo in Nigeria who work on zero commission or discount model and offer investing services in various securities like stocks, mutual funds, ETFs etc. through easy to use online apps.

Then, there are retail CFD brokers in Europe and Africa like IG, Plus500, Hotforex, FXPesa that allow investing in currencies, indices, commodity derivatives to smaller investors via online apps by offering leverage, this has popularized online retail forex and commodity trading.

However, despite this growth and ease of access, making a profit from securities trading can be very difficult. Trade Forex Nigeria warns, “New traders have a high chance of losing the money that they invest. They are often not familiar with how price movements occur in markets and they don’t have a strategy for trading. In Forex Trading, the percentage of losing traders is even higher than other trading instruments.“

This is why it is important for new traders to dip their toes into the world of trading by practicing through paper trading.

Paper trading refers to trading without investing real money, where brokers allow you to place simulated trades to buy and sell securities mimicking real market movements.

Many of the retail brokers also offer paper trading which allow traders to practice and learn. If used properly, it can be used to learn and practice trading by simulating movement of stocks, currencies pairs, commodities asset classes etc. in a test environment.

In this short guide, we will break down everything you need to know about paper trading.

What is a virtual/demo trading account or trade simulator? How does it work?
Paper trading is done through a virtual or demo trading account or a trade simulator. Such a test account allows you to access the market without having to risk any real money. You are provided with virtual currency by your broker that you can use to practice your trading.

In order to start paper trading, you will not be required to deposit any real money into your trading account. Several popular retail brokers offer a demo trading account or a trade simulator for free. Hence, you can practice trading without risking any money at all. If you do not like it or don’t want to continue for any reason, you can stop at any time.

The best way to start paper trading is to sign up for a free demo account with a stockbroker or CFD broker. You should ensure that this broker offers you free paper trading services. You can check whether they do so on their website or you can contact their customer support team and ask them.

Steps are simple: Sign up for a demo account at a broker, download the app, enter your login credentials in the app, start demo trading.

Why is Paper trading important? What does it tell you and who can benefit from it?
Every new trader can benefit greatly from paper trading. As a rule of thumb, you should practice trading by paper trading for at least a few months before you invest any real money in the markets. Apart from beginners, paper trading is also important for experienced traders who want to test new strategies or new risk management techniques.

Paper trading has many advantages. It allows a new trader to get the hang and feel of trading software and see how trading is done.

A new trader can also gain quickly gain experience on how price movements occur in the market and how unpredictable they really are. A trader can practice his trading strategies and see if they work in real conditions, without worrying about losing their money.

For example, suppose you want to start trading, but aren’t confident enough to invest your hard-earned money. Suppose your friends have started trading and have told you all about it. Rather than opening a real account with a broker, you should start paper trading.

Paper trading allows you to learn quickly and you can even test all your ideas and strategies beforehand. You will realize the market risks associated with trading which help you minimize your losses later on.

Understanding the Difference between Paper Trading vs Real Trading
There are a few differences between paper trading and real trading which you should understand.

When you’re paper trading, you will not need to deposit any real money. Paper trading is completely free. You will not need to pay anything for paper trading services from your broker. Brokers provide this service without any charge.

In contrast, when you want to do real trading, you will need to open a trading account with your broker. In order to do so, you will need to make a minimum deposit of real money with the broker. This minimum deposit can range anywhere between $5 to $500 depending on the broker. Further, when you do real trading, you will need to do it with real money.

When you take part in paper trading, you will not be able to realize any profits or losses from your trades. The point of paper trading is to help you practice trading, hence, you will not get any rewards or profits even if your trades do well.

In contrast, when you take part in real trading, you will realize real profits and losses. You can add to your bank balance by real trading. On the flip side, you may even face real losses.

You will not face any trading costs when paper trading. There are several types of trading costs associated with trading, including spreads, commissions, overnight fees (swap rates), deposit fees, and withdrawal fees.

When you’re taking part in real trading, you will need to account for these trading costs. However, as a paper trader, you will not be able to calculate or plan for these costs.

Paper trading cannot simulate the emotions and stress that a trader feels when actual money is on the line. Even though paper trading can match real trading conditions, it cannot provide the emotional turbulence associated with real trading in real-time.

This can be a major difference between paper trading and real trading since emotional stress accounts for a large portion of mistakes that a trader makes.

No Risk – This is the most obvious and the most beneficial pros of paper trading. A trader does not have to risk any real money with paper trading. As mentioned earlier, paper trading can be done completely free.

All you need is a laptop/smartphone and an internet connection. You do not need to pay the broker anything for paper trading since many brokers offer this service for free.

No Stress – Paper trading does not involve any stress on the part of the trader. Since paper trading does not need any real money and is completely free, a paper trader does not need to worry even if the screen shows huge losses.

Paper trading is for practice, hence, the consequences of facing a loss in paper trading is just embarrassment. A paper trader does not need to worry about losing money until they start real trading.

Powerful Learning Tool – Paper trading involves simulating real trading conditions as closely as possible. Hence, when you’re paper trading, you will be trading with real-time market prices and fluctuations. You will need to make quick decisions and implement effective risk management strategies.

While paper trading, you can use all the tools that you would use were you doing real trading. Hence, paper trading is a highly useful training ground.

Builds Confidence – As a new trader, you may feel that you’re an imposter in the world of trading and that you know nothing. Paper trading is the solution for that. Paper trading gives you the opportunity you need in order to practice and test your trading skills. If you do well in paper trading, there is a good chance that you will do well in real trading as well.

Even though new traders have a lot to learn, paper trading provides the fastest way in which traders can upskill and learn strategies and trading techniques. All this goes a long way in building the confidence of the trader.

Helps You In Building Strategies – As mentioned earlier, paper trading is a great way for you to test and build your strategies. Even though many strategies sound good in theory, they may not work in real market conditions.

This is why paper trading important since it allows you to test your strategies without risking your money.

Provides a Learning Experience – Paper trading provides you with the environment and the time that you need in order to build your trading expertise. It gives you a virtual platform where you can learn with no risk and no stress.

The lessons of paper trading are easily transmutable into real trading. Hence, your learning is real but your losses are not.

No Gains – Paper trading is completely for practice. Hence, even if a trader sees huge virtual profits from his paper trading activities, those profits will not translate into reality.

Hence, a trader needs to understand that paper trading may be boring at times, but paper trading can provide the tools and expertise to make real profits in the future.

Doesn’t Correlate to Individual Securities – Since paper trading mimics real trading conditions, it may not exactly provide the best way to judge the performance of individual securities.

For a large portion of the time, the behavior of individual securities mimics broader market conditions. Hence, it is difficult to narrow down the performance of individual securities as separate from the broader market while paper trading.

Doesn’t Provide Costs – As mentioned earlier, paper trading will not account for the costs that you may face while real trading. There are many costs involved in real trading. These costs include the spread, the commission, the swap rates, the deposit and withdrawal fees, the inactivity fees, and so on.

Devoid of Emotional Reality – Real trading takes an emotional toll. When you’re real trading, you will face a lot of stress from your open positions. However, paper trading is stress-less since real money is not on the line.

Hence, even though paper trading does a good job in mimicking market conditions, it does not do a proper job in mimicking what it would feel like when you’re real trading.

Formfitting – It is easier to pick and choose the ideal entry and exits points when you’re just trading on paper. However, there are many obstacles that must be faced when doing the same in a modern real trading environment.

Gamification – Paper trading gamifies trading. However, you should realize that real trading involves real risks. Hence, you should not be fooled when there are no real consequences to paper trading. When a trader starts real trading, they should be highly aware that the consequences are real and that this is not a game.