The Multiple Functions and Dysfunctions of Paper Trading

Dysfunctions of Paper Trading

Paper Trading, which is the action of purchasing and selling securities in a simulated environment, became a way for newcomers, amateurs and retail investors to learn the ABC’s of financial markets, create portfolios and learn new strategies. However, very few people go truly beyond and utilize paper trading once they believe they are ready for live-trading. This is a huge mistake.

Professionals paper-trade all the time. Not only it is a tool for portfolio managers to backtest their arbitrages, strategies and rebalancings, but it also shows the complete spectrum of ex-post results of possible decisions that might be taken at any point in time while at the same time considering the total costs of live-trading. To learn more on relationship trading strategies, arbitrage, and more, visit StockOdds.

Unfortunately, paper trading is often wrongly used by institutions and professors alike. When learning about capital markets, available investments, and risk, these agents tend to create paper trading competitions in which students supposedly learn to take decisions similar to those they will in live trading, but this is not true. In fact, these competitions mostly serve to reward the worst traders. Furthermore, retail investors believe that paper trading teaches you how to correctly manage money in a real environment. However, this is not true.

If you want to really understand what you should aim for while paper trading and how to use it at every stage of your financial journey, keep reading this post.

Common mistakes and misinterpetations of paper trading

As discussed before, universities and groups of people in general use paper trading supposedly to learn how to invest money in different securities. However, the paper trading competitions in which the agents learn to take money decisions is detrimental to their knowledge in capital markets. To begin with, the winner is commonly the one who, after a period of time, has earned more money. This goes against the very concept of long term survival. The incentives for participants are for them to invest in risky assets that, in the case of real trading, could cause them great harm.

Long term survival is the first thing investors should strive for. By having the wrong incentives, prudent investors are punished while nonsensical risk takers are rewarded and bear no responsibility for their decisions.

Another aspect to take into account is that paper trading is said to be good to learn how to manage a stock portfolio. Unfortunately, this is false too. How can you learn to manage money if you don’t feel the same emotions that you would when actually loosing or winning money? We, as humans, take decisions mainly driven by feelings. Only those who have been 10%, 20% or more down on an investment that was thought to be perfect can understand it. Is it possible to feel Fear Of Missing Out (FOMO) without seeing everyone else euphoric? Moreover, money that’s been won must also be correctly managed. The temptation of closing winning trades is more than common.

In short, you will not learn to manage money without actually managing real money.

All these characteristics make paper trading a harmful activity for newcomers and students when it is poorly understood. Conversely, well executed plans and exercises on paper trading make it a powerful tool for amateurs and professionals alike.

Understanding and applying paper trading correctly

At every stage of your journey in capital markets, paper trading can be a useful friend for different purposes. Most people have their first experience in markets through paper trading, and seasoned professionals use it to test their decisions.

If you are just curious about managing your own portfolio, paper trading is an ideal tool for getting to know the platform in which you will place the orders, the specific types of orders (market, limit, stop order, etc.) and all operative aspects of investing. This includes everything from understanding all information provided by the platform and its correct interpretation for decision-making, to confidence building and mistake prevention. In addition, all paper trading for testing a platform should be done taking into account the cost of fees.

Investment analysts and intermediate professionals paper trade to test their strategies and develop new ones. This creates a track record and analysis which is then filtered, adding new information to take decisions in live trading. For example, this is the case of technical and fundamental tactics to allocate money. Investment professionals look at the past performance and price-action of an asset and then choose different variables that might explain those swings. By filtering past information (normally via regression), they can see which variables are relevant for that asset and then, via paper trading, apply the strategy in a simulated environment. The turtle strategy developed by Richard Dennis and William Eckhardt back in the 80s, was one of the first cases of successful implementation of backtested strategies.

Paper trading is also used by experts and portfolio managers to test asset weights and past performance of thousand or even millions of simulated portfolios based on past data. Again, this is filtered not only to reveal relevant variables but also to apply different criteria to these simulated portfolios. By doing this, and with the help of quantitative analysts, experts decide which assets suit a strategy, in which degree should they be added to the portfolio and the “if” scenarios that may arise. Finally, qualitative data and new information are included in these complex models to take decisions. Of course, not always complex is better, but once a winning strategy is found, investors exploit it as much as they can.

Key Takeaways

  • Paper Trading is a powerful tool used by amateurs and professionals alike.
  • To manage money, you must manage real money.
  • Long term survival is the first thing investors should strive for. Paper trading does not teach this.
  • Feelings play a huge role for retail investors.
  • Newcomers use paper trading to understand basic information, costs, price action of securities and confidence building.
  • Professionals at every stage use paper trading to test strategies of different levels of complexity.
The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The World Financial Review.