Financial Markets are generally unpredictable, and if you are not prepared enough to deal with the uncertainty entailed, you are on the verge of losing a lot of money!
Well, there is a way not to get directly involved in live trading using real money and that is done through virtual money. Virtual money in this context is the money which cannot be transacted in the real world but can be used for placing paper trades.
Paper trades are those trades where one can buy or sell securities without risking any real money. This whole mechanism of using virtual money for placing paper trades is known as “Paper Trading.”
Paper Trading is very helpful for beginners who want to learn how to trade in the financial markets and also for experienced traders who want to test their trading strategies without risking any real money as mentioned before.
It not only serves as a platform for learning to trade practically but also tests the capability to handle situations when the market direction is moving against the initial position taken.
In this article, we will go through the concept of Paper Trading and how it is a better way to test your strategies before deploying the strategy in the live markets!
Below, is the list of topics covered in this article:
- Brief Description About Market Microstructure
- Backtesting vs Paper Trading
- Why Do Traders Paper Trade?
- Paper Trading Platforms
- Paper Trading Games
- Psychology of Paper Trading
Brief Description About Market Microstructure
When you start to trade, there are a lot of factors you have to take into account or it could hamper the entire strategy, however good the trading strategy is!
Listed below are the market nuances which can be mastered using Paper Trading:
Type of Order
Market order is a type of order where you place your trade order at the market price or at the last traded price. On the other hand, limit order essentially means placing the order at a fixed price.
If instead of placing a market order, you place a limit order, there is a high probability that the trade might never be executed and all your hard work might go into vain as the current trading price may never hit the limit order price.
Using Paper trading, the skills required to learn such market microstructure nuances can be sharpened which is clearly an advantage during live trading which involves risking real money!
Other types of trade orders include:
- Good till Cancelled(GTC), and
- Immediate or Cancel orders(IoC).
In GTC, the trade order is executed if completed or else cancelled. In IoC, the trade order is immediately executed either in full or a portion of the total quantity of the order. The unfilled or unexecuted orders are immediately cancelled in IoC order type.
Application of theoretical concepts
There are multiple strategies which might look to be lucrative and would make perfect logical sense to implement in the live markets but in reality, they might work differently than what was initially expected!
For example, options strategies: covered call and naked put are more or less the same theoretically. However, when we trade live in the markets, the strategies perform slightly differently.
The covered call strategy involves holding the underlying asset, however, naked put doesn’t. This is why the payoffs can be very different from each other, leading to a difference in break-even point, even if both the strategies involve selling options at the same strike price with the same current market price.
To learn more about market microstructure, check out this article - What Is Market Microstructure?
Before we move on to paper trading, let us understand how it is different from backtesting.
Backtesting vs Paper Trading
Let’s take a look into some of the differences mentioned below:
Whenever you test a new trading strategy using the same parameters as the one to be deployed in the live markets using historical data i.e. past OHLCV data, the entire process is known as backtesting.
However, when we test the trading strategy, there is a probability of overfitting the historical data. Overfitting means that you will modify the parameters of the strategy in such a way that the profit margins look absolutely perfect and overwhelming!
Take, for example, the below mentioned backtesting result.
Backtesting Results - 01-July-2018 to 01-Sept-2018
The returns graph is for a pair trading strategy using the Indian stocks of TATA Motors and TATA STEEL, which have a high correlation value as they are part of the same conglomerate TATA Group. Two months of historical data with the implemented strategy gives a return of 25.16%.
However, if on the day of 01st September 2018, you would have used the same strategy and deployed your capital live in the markets for the next year, the return results would have been a lot different than what you would have expected!
Backtesting Results - 01-10-2018 to 01-10-2019
This uneven backtesting result of 25.16% for the first backtest was because TATA STEEL had strong positive sentiment as it had doubled its net profit margins for Quarter 1, given its strong Europe Sales.
On the other hand, TATA MOTORS had strong negative market sentiment due to falling car sales data and the impact of Kerela Floods had further depleted TATA MOTOR’s stock price. Using a Pair Trading Strategy, where the prices are expected to reach its mean price levels, this unusual net profit result was received.
On the other hand, for the next year, the prices really did not move far away from the mean prices which generated only returns of 19.39% for the second time period.
Using Paper Trading, which simulates live trading, there is no scope to use price data in a way that would showcase outlier results as paper trading uses live data which keeps flowing in and is not static.
While backtesting involves only testing the trading strategy based on parameters and observing if the trading strategy would work in live markets or not, it does not really involve trading using live data.
In Paper Trading, we are using our strategy on live data and there is little scope to change the initial parameters. Thus, you can see if the parameters you have set will generate the expected returns or not.
Paper Trading involves deploying the trading strategy in the financial markets using live data. Unlike historical price data, live data comes as a surprise to the human eye and as an element cannot be controlled or manipulated during the entire trading day.
However, in backtesting, the historical price data has already been seen by the back tester and the element of surprise is lacking. Now, this element of surprise and the way we react to the market data is what makes a good trader, a great trader!
Slippage and commission
Slippage generally means the difference between the execution price and the entry or exit signal price for a financial instrument. While Backtesting does not take into consideration the occurrence of slippage while providing results, Paper Trading provides real-time experience to get acquainted with slippage costs.
Similar to slippage, commission cost is another type of variable cost associated with the execution of trades. Even though commission costs can be added to the historical prices before backtesting the strategy, there are still chances of a spread between the commission costs included and the actual commission costs for the trades.
Therefore, Paper Trading actually helps in understanding these factors and overcoming these minute difficulties while trading live using real cash!
But now you might be asking if these are the only reasons to paper trade. Let's find out a few more reasons in the next section.
Why Do Traders Paper Trade?
Let’s say you have backtested a strategy and it looks awesome. 400+ percent returns in 3 years. The drawdown of 50% is a bit worrisome, but then the 4 times returns is enough to make you say that this is a good strategy.
But a small part of your rational brain asks is it a good strategy?
Can we do something else to build your confidence. Paper trading is perfect for this situation. You are using the strategy on live data but it is not your real money. Thus, you will understand if the strategy works in the live markets and gain the confidence to take the strategy live.
Check deployment issues
Another advantage of paper trading is that you will understand how your orders are getting filled and is there a slippage. Also, you will get to know the trading platform and how it works.
Any bug over here can be identified and worked on so that you can deploy the strategy in the live markets without any hiccups.
Does the strategy perform as expected?
Is the strategy which gave an annual return of 40% performing as expected in a time period of three months in the paper trading environment?
In paper trading, you can keep a track on the trades and check if the strategy performance is in line with the backtesting results.
While paper trading helps you understand the market. It also helps you understand yourself. You know that fear and greed can drive your decision making process and should be kept in check. Let’s take an example here.
This is the price graph of Apple. Or rather, the split-adjusted price graph of Apple. Let’s say you invested in Apple at $50 on May 2019. And you were amazed when it crossed $80.
But then the price started falling on February 2020 due the Covid-19 pandemic. A freefall from $80 to $56 in barely a few weeks. It would be difficult to hold on to your position in such a scenario.
Of course, the price of Apple not only bounced back, but touched $140 in 2021. This example serves to illustrate that when your real money is on the line, it is hard to stay in position which is declining sharply.
Let us see a few paper trading platforms now.
Paper Trading Platforms
Paper Trading platforms are either technology companies or online brokers. They either provide paper trading in the format of a virtual game or the general way of providing a paper trading account in complement to a real trading account.
The major difference between online paper trading broker platforms is the experience they provide to a trader and facilities provided by them. Lets us take a look as to what makes the difference:
Interactive Brokers (IB) has a fantastic paper trading platform to get started with your virtual trading experience. It has all the tools ranging from real-time charts, technical analysis tools, option pricing analytics, etc.
Anyone can start with a USD 1,000,000 virtual cash with an option of resetting the cash equity position at any point in time. The key differentiator for IB is its simple market news and data platform coupled with excellent trade execution success rate.
However, there are certain limitations like non-execution of certain strategies, for example - VWAP. Also, it provides only level 1 data i.e. limited order book data for paper trading and a market lag of 10-15 minutes depending on the asset class. However, the biggest advantage with Interactive Brokers is the support it provides for automating your strategies.
One can easily automate the strategies using Interactive Brokers.
Paper Money by TD Ameritrade is also a very efficient online broker platform to paper trade. It too starts with a USD $1,000,000 account and unlike IB executes most of the strategy types.
The issue with TD Ameritrade is that it does not allow customers from every country to open an account with them. However, it has a lot of differentiating points when compared to other brokers.
It has a social sentiment indicator which mentions the sentiment that traders have for a particular trading asset. Below is an image portraying the same sentiment indicator.
Alpaca is a famous platform for automating your paper trading strategies. It uses IEX Data (IEX is one of the exchanges in US Markets). It uses two APIs for trading, one that serves as your ID and another a secret key.
It’s interesting to note that Alpaca provides 4x leverage on the initial cash of USD 100,000.00 so that the traders can practice margin trading using the leverage provided.
Along with its algo paper trading platform, it offers manual trading in partnership with Tradingview.com for diversified paper trading experience. It supports programming languages like python, C#, Go and Node.
Tradestation is another online broker which provides simulated or paper trading experience to its users. The key differentiator here is that it has two market data categories: Real-time data and delayed data.
For real-time data, it charges a minimum fee and for delayed data, the amount is nil. Also, you cannot open a paper trading account until you open a live trading account, which charges a USD$5000 as account opening minimums.
If you want to start paper trading in the Indian markets, using ICICI Direct would be a good call. Here, the asset class is just not limited to equity but also includes derivatives. However, the platform does not support automated trading as of now.
Paper Trading Games
Paper trading games as the name suggests is another way to paper trade where a simulated game experience platform is provided by brokers for making paper trading more exciting and competitive for novice traders.
Listed below are some of the most famous paper trading game platforms and their individual nuances:
Moneybhai by moneycontrol.com has a paper trading game platform where they require every participant of the game to follow a set of rules to play the game of paper trading.
They provide every participant with virtual cash of Rs 1 crore which needs to be squared-off if you are taking intraday positions. To put it in simple words, you need to liquidate your long and short positions if you are trading on an intraday basis.
This was one of the rules that a participant needs to follow. You can check the other rules here.
When it comes to paper trading games, Market watch (a Dow Jones & Company subsidiary) is an excellent platform to begin competitive paper trading. The idea is quite simple, you need to create a game or participate in an already created game.
We have tried to demonstrate how to create a game in the below images:
Psychology of Paper Trading
There is a famous quote, “It’s business, leave your emotions at the door”, from the movie - The Wolf of Wall Street. While this quote points out the eternal truth that exists in the Financial Markets, traders more often get caught emotionally during live trading sessions.
Although paper trading provides a great platform for testing trading strategies beforehand, there are a few points that a novice trader should keep in mind before proceeding with it:
Virtual Trade Mindset
Since Paper Trading is a platform that uses virtual money to trade.
There can be a psychological barrier in a trader’s mind that:
- he/she is using virtual money and
- whatever position has been taken therefore has zero possibility of losing real money.
Therefore, rather than using this platform to enhance trading skills, it becomes a platform for taking long and short positions without serving its real purpose.
Therefore, you must always keep in mind that even if paper trading uses virtual money, seriousness while trading is extremely important to extract the intrinsic value. You should always trade thinking it is your real money on the line.
Following the point of virtual-trade-mindset, the issue of up-scaling capital is very prevalent with Paper Trading.
For example, when the direction of an equity stock’s price moves against the initial trade’s position in live markets, a trader usually would think multiple times before putting in more money to the initial position.
However, since paper trading uses virtual money, a novice trader can further buy/sell the same equity stock to supplement the initial position. This creates a huge difference between paper trading and live trading.
This makes it essential to be aware that trading is based on tough decisions and the platform of paper trading should be used wisely to inculcate that skill.
While risk is the probability of losing money while trading in the markets, this psychological parameter is very prevalent among traders. Fear and Greed are the main components of market sentiment which is, and will always exist in the financial markets.
When a trader uses paper trading platforms, a mindset to acknowledge the risk associated in the markets should be factored. Your capital should be equal to the capital you would have invested in the live markets.
If you are planning to invest $10000, then it doesn't make sense to have $1 million in your paper trading account.
Build a realistic portfolio
It is easy to buy 1000 shares of Apple on your very first paper trade. However, in reality, there are very few chances that you would be taking a long position in 1000 shares of Apple in the very first trade using real money. Thus, build a portfolio which is similar to the one you would build using real money.
Risk Management Techniques
Paper Trading serves the purpose of learning risk mitigation techniques in the Financial Markets. Using risk management techniques you can easily curb your losses which might hamper your profits on a bad trading day.
There are market factors which have a big impact on the profit margins for a trader. For example, the concept of stop loss or take profit may look very lucrative and perfect theoretically, however, when we try to set the stop loss or take profit parameters, there are multiple factors to consider.
This may be the stop loss value, the trailing stop loss value or even the take profit margin. Once we trade in the markets, if the price of the underlying asset moves as per our prediction, we tend to increase or decrease stop-loss as the case may be.
This whole dynamic mechanism of increasing or decreasing stop-loss and the take-profit parameter is a very important skill for a trader and can be optimized using paper trading.
Understanding Market Sentiment
Similar to live trading, asset prices move in accordance with market events in paper trading. For example: Generally, whenever there is an earnings announcement to be made by a company, markets usually tend to be volatile.
A novice trader can take a position after understanding the market sentiment and can trade thereon. Even if the markets do not move in the expected direction, he/ she can learn the impact that the news actually has on the markets.
This experience over a period of time gives a strong mental holdup for taking positions in the live markets. This whole process inculcates confidence in the trader to create strategies and execute them after logically analysing the whole situation at that point in time.
Check metrics regularly
To get the most out of paper trading, you should check the performance of your strategy regularly. This will help you understand how well it is performing and give you the confidence to go live. Or to shut everything down.
While trading can feel like a battle, the key to success always remains in holding your nerves tight in difficult situations. Discipline in trading can only be built through practice and a set of smart rules.
For example: Setting the stop loss at below 2% the current levels or take profit at 2% above the current market levels is easy, however when the price of an asset falls or rises to the stop-loss or take-profit levels, a trader might change the margins to lose less or to earn more profits.
Therefore, in order to handle situations like the one mentioned in the example, one should be disciplined and emotionally neutral. This habit is built over the years, so anyone in the financial markets can use paper trading to build trading discipline.
While trading in the financial markets using virtual money, one does make mistakes in terms of taking incorrect positions or incorrect trade order size for a position or even the timing of the position.
These mistakes help in understanding the market better and how it reacts in different situations. Therefore, Paper Trading acts as a reinforced learning platform for the traders while testing a new strategy or even after testing a modified strategy.
If you wish to learn how a strategy can be deployed in a paper trading environment, check out this complete recording of the webinar - How Paper Trading Can Make You A Better Trader
Paper trading is a great platform to test your trading strategies in live markets without using real cash after backtesting the strategy on historical data.
As mentioned in the article, there are several broker platforms to test your strategies. I would recommend you to check all the mentioned broker platforms to find the platform that suits your needs the best.
Also, as mentioned, paper trading requires one to have the right trading ethics to simulate live trading in the best way possible.
Take your first step to automate and execute trading strategies in Python in this course offered by Interactive Brokers and Quantra - Automated Trading with IBridgePy using Interactive Brokers Platform.
If you plan to learn algo trading in a structured manner from the best in the industry, EPAT is the best suited course for you. EPAT is an algorithmic trading course by QuantInsti which is widely regarded as one of the courses to learn quantitative trading.
Disclaimer: All investments and trading in the stock market involve risk. Any decisions to place trades in the financial markets, including trading in stock or options or other financial instruments is a personal decision that should only be made after thorough research, including a personal risk and financial assessment and the engagement of professional assistance to the extent you believe necessary. The trading strategies or related information mentioned in this article is for informational purposes only.