The stock market can be intimidating. You see people making a lot of money and you’d like a piece of the action, but you also see people losing. You have ideas for potential strategies, but using them unproven is a huge risk. Backtesting and paper trading can help clear up some of the uncertainty.
There are two basic ways to test out a trading strategy without risking money.
- Backtesting looks at how a strategy would have performed in the past, using historical data.
- Paper trading is a form of forward testing. You trade with a mock portfolio to see how your strategy plays out in real time.
These methods have limitations, and they are no substitute for actual experience in the market. They can still be useful tools in preparing you for a dive into live trading.
Let’s take a closer look.
Before we begin, we should outline a few terms related to paper trading and backtesting.
- Paper trading allows you to practice trading without risking real money. You simply log your trades in real time in a journal, spreadsheet, or stock market simulator as if they are real trades. However you choose to do it, you need to make it as realistic as possible. So, you can only use the current market price and you must account for slippage and the commission you would pay if you were trading with real money. Paper trading is sometimes known as demo trading, virtual stock trading, or simulated trading.
- Backtesting is the process of evaluating a trading strategy using historical data. Typically backtesting is done using software, but it can be done manually by logging each individual trade. Backtesting can only be used for rules-based strategies where each trade follows exactly the same set of rules for trade selection, entry, and exit. When you backtest a strategy, you will be looking at the performance over a series of at last 20 trades to see what the overall results will be.
- Live trading is real trading with real money. Obviously, live trading in the real market is the objective for any trader. But live trading with a very small amount of capital can also be part of the practice and testing process, along with paper trading and backtesting.
- Demo accounts, which are also known as stock simulators and virtual trading accounts, are trading accounts that let you trade with virtual money. Most stock brokers offer paper trading with a demo account like this. Not only does this allow you to practice trading and evaluate your strategy, but you can also get to know a trading platform before you put real capital on the line.
Let’s look at some reasons for starting with demo trades before you try live trading.
How to Use Paper Trading and Backtesting
Paper trading and backtesting require sophisticated tools to replicate the experience of trading with a real portfolio (paper trading) or to apply the parameters of a trading strategy to past market conditions.
Luckily we have access to tools developed specifically to make paper trading and backtesting easy.
We’ve published separate articles on the best paper trading tools and how to use them and the best backtesting tools and how to use them.
Why Paper Trade or Backtest Before You Risk Real Money
Trading is a numbers game, and there is a fine line between being profitable and unprofitable as a trader. Backtesting and paper trading help you increase the chances of being on the right side of that line. Not all trading methods can be backtested, but if you can backtest a strategy, you will know what to expect when you go live. By backtesting your trading strategy you can:
- see how the strategy would have performed in the past,
- calculate your win rate and reward-to-risk ratio,
- find out when the strategy might fail, and,
- optimize the parameters of the system to improve performance.
By paper trading your strategy you can:
- evaluate the strategy in real time,
- Compare real-time results to backtest results,
- find out how much slippage you can expect, and,
- see if there are any other issues related to real-time execution.
In addition to testing strategies, paper trading is a useful exercise for traders of all levels:
- Beginners can use paper trade accounts to learn how emotions can affect decision-making.
- Traders can get to know a new trading platform with a demo account before risking capital.
- You can experiment with different order types and risk management strategies.
- You can build confidence after a difficult period. Even the most experienced traders sometimes revert to trading with a stock market simulator after a string of losing trades.
These strategies allow you to make mistakes and learn from them without risking your hard-earned capital.
Paper Trading vs. Backtesting vs. Live Trading
Ideally, the process of developing a new trading strategy should include the following steps:
- Backtesting and optimization
- Paper trading
- Live trading with minimum possible capital
- Live trading with increasing amounts of capital
Each of these steps can teach you something new about the strategy and minimize the amount you put at risk before you are sure it’s profitable. The reality is that you may not be able to use each step for every approach to trading. There are also a few distinct differences between backtesting, paper trading, and live trading in respect to when and why each is useful.
When to Use Paper Trading and Backtesting
Paper Trading and backtesting can be used by anyone who trades stocks or wants to trade stocks. Even experienced traders use these methods before adopting a new strategy or changing an existing one.
There are still some situations where these methods are particularly useful.
- You want to move from investing to trading. If you’re already holding some stocks long-term and considering trading more actively backtesting and paper trading can help you prepare.
- You’re trying to decide between investing and trading. If you’re ready to dip into the stock market and aren’t sure what approach you want to take, these tools can help you evaluate your trading ideas and compare them to more conservative strategies.
- You’re saving money to invest. If you aren’t ready to invest yet but you’re working toward that goal, backtesting and paper trading are a great way to get familiar with markets and how they work.
- You’re just interested. Even if you’re still in school or beginning to build a career, you can look forward to when you’ll be able to enter the market. The more you learn the better prepared you’ll be.
Both paper trading and backtesting work best when you have a clear strategy to evaluate, but you don’t need just one. You can try out several strategies, compare, and develop as you go along.
Conclusion: Stock Market Simulators and Backtesting Tools
Both paper trading and backtesting are a crucial part of the trading process for beginners and experienced traders alike. In fact, testing your strategy and skill before going live can be the difference between taking educated risks and gambling. By using a stock market simulator and backtesting tools, you can ensure that you really have an edge before you put precious capital on the line. What are your favorite paper trading and backtesting tools?
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