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Muslim man engaged in paper tradingInvesting in the stock market can help you build a portfolio and grow wealth. But there is a certain amount of risk involved when purchasing stocks and other securities. Paper trading is something you might consider if you’re a newer investor who’s still learning the basics of how the market works. Though it may sound like a complicated concept, it simply involves creating hypothetical trades on paper without actually placing them in the market. Paper trading is relatively easy to do, though it does have some pros and cons to keep in mind.

What Is Paper Trading?

Ordinarily, trading involves placing orders to buy or sell specific securities on an exchange that trades equities and bonds, among other securities. For example, you might place an order to buy 100 shares of XYZ or sell 20 shares of an exchange-traded fund (ETF) that you own.

Trading can be profitable if you’re able to sell securities for more than you purchased them. But it requires you to invest your money and take on a certain amount of risk. If you purchase a stock in the hopes that it will go up in value but the price nosedives, for instance, you may end up selling it at a loss.

Paper trading allows you to trade stocks and other securities hypothetically, without putting any of your money at stake or taking on any risk. It’s called a paper trade because you’re simply writing down trades on paper (or recording them in a spreadsheet) then tracking how those securities perform over time. Though it’s technically digital, you can also do paper trading using online stock trading simulators.

How Paper Trading Works

Man uses a paper trading appPaper trades can be used as a training tool to help you get familiar with the market and its movements. It can also be a way to test out ideas for more experienced investors as a means of gauging potential outcomes. If you want to make a paper trade, all you need to get started is a pencil and paper as well as an idea of which stocks you want to trade. You could choose a specific security, such as a stock or ETF, that you want to buy. You’d write down the price point at which you want to buy that security and the price point at which you’d want to sell it.

Once you’ve made your trade on paper, you’d then track that security’s price movements to see how much you might have gained or lost if you’d actually executed the trade in real time. It’s a simple way to predict how accurate your guesses about a particular security might end up being. Since you’re not investing any actual money in the market, you’re not at risk of losing anything if your hunch doesn’t pan out.

Paper trading does require you to have some basic knowledge of how trading works. For example, you’d need to know the difference between market orders, limit orders and stop-loss orders. A market order is an order to buy or sell a security right away once it reaches its best available price. Limit orders are orders to buy or sell a security at a specific price or better. Stop-loss orders are orders to buy or sell once a security hits a certain price.

Pros and Cons of Paper Trading

There are both advantages and disadvantages associated with paper trading. Weighing the pros and cons can help you decide if it’s something that could be useful to your overall investing strategy.

Paper Trading Pros:

  • Risk-free trading. Since you aren’t investing real money into the market, you’re effectively taking no risk by making paper trades. That’s an advantage if you’re new to trading and you’re not yet comfortable putting your money on the line.
  • Learn the ropes. If you’ve never traded stocks or other securities before, you might feel a little intimidated or overwhelmed at the start. Paper trading offers a safe space to learn the basics before you begin investing with actual money.
  • Avoid investment biases. There are a number of biases that can drive investment decision-making and they don’t always work to your advantage. Trading on paper can help you avoid things like recency bias or following a herd mentality because it’s easier to tune out the background noise in the markets.
  • Grow confidence. Trading stocks on paper can help you feel more confident in your abilities once you’re ready to make the transition to real-world investing. It can be a good warm-up for beginners who have never traded before.

Paper Trading Cons:

  • Risk tolerance may be skewed. Trading on paper without putting any money at stake could cause you to surpass your natural risk tolerance level. If those paper trades pay off that could instill a false sense of confidence and lead you to take more risk than necessary once you start making real trades.
  • No room for profit. While paper trading won’t expose you to losses it also doesn’t offer any opportunity to reap profits either. If you prove adept at making paper trades but are hesitant to move off the page and into the market, you could miss opportunities to grow wealth in your investment portfolio.

How to Start Paper Trading

If you’re interested in becoming a paper trader, there are a couple of ways you can do it. As mentioned already, you can track trades on paper or using a spreadsheet. But you may find it easier to use a virtual trading software or online platform.

Digital trading simulators can more closely mimic the experience of making trades online. You can gain trading experience in real-time (or something very close to real time) and see how stock prices can change throughout the course of the trading day. Some of these platforms also offer research and analysis tools that can help you learn the ins and outs of the market.

If you’re considering an online paper trading platform, pay attention to things like:

  • Types of hypothetical trades you can make
  • Whether pricing data is real-time or delayed
  • Accessibility and convenience online and via mobile apps
  • Market research and analysis tools
  • Any fees you might pay to use the platform

Keep in mind that if you’re interested in using an online brokerage’s paper trading platform, you may first need to open a brokerage account before you can use this feature.

The Bottom Line

Investor monitors his stock trading simulatorPaper trading can be a good way to begin familiarizing yourself with the markets and how they work if you’ve never traded before. And experienced investors can also benefit from paper trading when investing in more speculative securities, such as futures or options. Whether you choose to paper trade by hand or online, remember that it is hypothetical and your real-world trading results might work out differently.

Tips for Investing

  • Consider talking to a financial advisor about paper trading and whether it could be a useful tool for your investment strategy. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’s financial advisor matching tool makes it easy to connect with professional advisors in your local area in minutes. If you’re ready, get started now.
  • When opening online brokerage accounts to take advantage of paper trading or to start trading regularly, pay attention to the fees you’ll pay and the range of securities you can invest in. While many online brokerages offer commission-free trades for stocks and ETFs, not all of them do.

Photo credit: ©iStock.com/visualspace, ©iStock.com/sefa ozel, ©iStock.com/LanaStock

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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