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Stock Market Trading -- Does Paper Trading Work?

By  Jul 28, 2011

Topics: Finance & Investing

Paper trading -- using a virtual account and trading with non-real money in a real time market setting --  may be a great way to learn the terminology, trading rules and restrictions, and most of all, to find out whether a theory produces profits or unexpected surprises.

Much of actual trading involves risks that novice traders might not be aware of until it is too late. So paper trading is a good way to get familiar with the market, but it also has some severe limitations, so it is only useful in a limited way and for a limited time.

Among the drawbacks to paper trading:

1. If it isn’t real money, it isn’t real experience either. If you lose in a virtual trade, it’s a lesson learned in theory. But sadly, when you lose real money, the “loss theory” hits you nice and hard. This is where actual experience comes from. You don’t forget losing money, but you can easily overlook the virtual trade losses you have along the way.

2. You will not always trade in the same way when you know it isn’t real money. Anyone who has played Blackjack on Yahoo! knows how easy it is to bet $1,000 on every hand. You can easily run your pot up $100,000. But in Las Vegas, few people will actually put $1,000 on a single hand, and even fewer will be able to run it up to $100,000. As a result, the online version of no-risk Blackjack is not the same as being there.

3. If you paper trade too long, you could get an unrealistic view of the trading world. You can be sure that you are going to make decisions with real money in a much different way than you do with virtual money. So paper trading can convince you that making money is all too easy; but then you put real money on the table and it goes south. Pilots know that if they spend too much time training other pilots, they can fall into a training mode and make disastrous mistakes when they go back to actual flying. Some investigators have speculated that pilot error causing plane crashes may often be caused by pilots’ brains thinking they are in the simulator instead of in the real world. The same caution applies to paper trading for too long.

4. Risk levels are different, too. Paper traders, because no real money is at risk, can afford to make bold, even high-risk decisions, keep positions open longer than they should, and even try strategies beyond their risk tolerance. So what do they learn? Once they start trading for real, they will either ignore their risk level or change the way they operate. In either case, they have not learned the right lessons from paper trading.

There are a few pitfalls to paper trading. Even so, it is a valuable tutoring method for you to learn about options trading and how real world values rise and fall. Just remember that it is a simulation and not real. Once you make the transition to using real money, take your paper trading lessons with you. But don’t forget to keep the paper trading experience in perspective.

Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches five  courses: “Swing Trading with Options,” “The Amazing World of Options,” “Synthetic Options Strategies”, “Options timing and dividend income strategies,” and “Using candlestick reversal and continuation patterns to improve timing.”  He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks. He also contributes to several blogs: CBOE, Seeking Alpha and the Global Risk Community.