The demo or practice account provided by online brokers is essential for forex traders, especially newbies. It allows beginners to test their strategies and gain experience without risking real money. Before this, traders used to jot down their trades on paper (which is where the term paper trading has come from), missing out on the real-time market experience. Thankfully, there are online demo accounts where traders can experience the thrill of the market without any financial risk.

What is paper trading?

Paper trading is a technique that allows you to make fictitious trades in a simulated trading environment, which is also commonly referred to as a simulator. You can get access to these accounts through your broker’s website or MT4 or MT5 platforms. This is especially beneficial for new traders trying to understand the market and seasoned traders trying to test their trading strategies.

While beginners can use paper accounts to practise trading, testing a strategy in a simulated environment might help experienced traders spot any possible risks, even if they’ve extensively backtested it using historical pricing. We all know how common it is for seasoned traders to unintentionally inject bias or overfitting into their methods, which results in future underperformance. Paper trading can help you avoid these risks by enabling you to test your methods with virtual money before risking real funds. You should also make a habit of calculating your profits and losses. There is a profit calculator available for that purpose. Similarly, If you want to know the number of pips you’ve earned in your currency, then you can use a pip calculator for that. There are calculators available to calculate other aspects of the trade as well, such as margin, position size, lot size, leverage and more. Using these will help boost your chances of becoming profitable in live trading by using paper trading to hone your strategies.

Is paper trading the same as real trading?

Even though it is a useful tool for traders, paper trading is not precisely the same as real trading. Even though paper trading is effective at mimicking the market, it cannot completely duplicate the intricate market microstructures in live trading. This may result in differences between a trading strategy’s performance in a paper trading environment and a real trading environment.

For instance, the psychological aspects of paper and live trading differ. Trading on paper doesn’t trigger emotions to extremes, but real trading might result in an exaggerated sense of confidence, fear or maybe greed. Additionally, compared to live trading, the danger of addiction and the effects of loss aversion are less severe in paper trading.

Technical Differences between paper trading and real trading

• Market impact is the influence of your orders on the supply and demand of the trading asset. Your trade may have an effect on the market and the price if you are dealing with a large order or an unstable item. This might result in slippage, which is the discrepancy between the price you expect and the amount you actually pay for your order. Although paper trading simulators can help you estimate the fill price you would have for your order in a live market, they cannot consider your transaction’s effect on the market. Simulators employ actual market data, and the prices reported only fluctuate as a result of actual transactions, which explains why.

Therefore, paper trading may not accurately depict reality if you are simulating large orders or trading low-volume assets.

• The order book may provide a wealth of information regarding a trader’s conduct when it comes to trading on financial markets. In addition to adding to the order book, placing a limit buy or sell order might reveal information about a trader’s trading style to the market. This is especially alarming for traders who worry about information leakage because it might give market makers and high-frequency trading algorithms an unfair advantage in forecasting the next price move.

However, this problem does not exist for simulated orders. There is no chance of information leaking because they are not included in the actual order book. Simulated orders, especially for illiquid assets or big orders that have the potential to disrupt the order book, may not, however, fully reflect the impact of a genuine order.

Furthermore, market makers may stop trading if there are unexpected spikes in buying or selling activity. In such circumstances, the market makers can infer that a news event is to blame for the order book imbalance and that traders act based on incomplete information. This may increase market volatility and have a bigger effect on price. In order to minimise information leakage and market disruption, traders should be aware of the potential effects of their orders and take the necessary precautions.

• The problem of latency becomes more important when using algorithms for high-frequency trading. The time elapsed between sending an order and the exchange executing it is referred to as latency. This may significantly affect how much a deal is done. There will be a lag between the time the order is issued and the time the exchange actually executes it, for instance, if you receive real-time data from a broker and your algorithm generates a signal to transmit an order. Many things can contribute to this delay, including how long it takes for the order to be acknowledged and sent to the exchange. This delay might not be noticeable if you trade liquid assets during regular trading hours. However, even a slight delay might cause a considerable price slippage when it comes to illiquid assets or during extreme volatility. Using a simulator for paper trading is one technique to get around this problem. The order-to-trade delay is eliminated since simulated orders are not delivered to the exchange. You can use trading calculators to quickly determine the effects of latency on your trades. Even though a simulator might not accurately simulate real-world latency, it can provide most traders with a fair approximation.

Psychological differences between paper trading and real trading

1. Risk aversion is the tendency for people to choose outcomes with lower levels of uncertainty over those with higher levels of uncertainty, even when the average returns are the same. A person’s risk profile may be visualised as a risk-return curve, with more risk requiring larger returns.  However, using fake money in place of real funds while trading on paper might result in a skewed risk aversion profile. Traders may use riskier techniques than they would in real-world situations. According to research, people are often more sensitive to losses than they are to similar gains. The financial markets, where traders feel the anguish of losing money more keenly than the joy of making money, are particularly pertinent to this occurrence. This is referred to as loss aversion, and it can cause traders to hold onto assets for an excessive amount of time in an effort to prevent losses, even when it is obvious that the asset is underperforming.
2. In terms of algorithmic trading, loss aversion can also affect traders’ decision-making processes. Loss aversion can have an impact on systematic traders who use computers to make judgements. A trader may decide that a strategy is no longer successful after a string of losses for an algorithm and stop using it. This choice, however, could be hasty because the losses are the outcome of chance rather than an error in the algorithm. Anyone participating in the financial markets must comprehend loss aversion and how it affects traders’ actions. By acknowledging the tendency to avoid losses, traders can develop more resilient strategies and be better able to withstand periods of poor performance.

Conclusion

If you’re considering stepping into the world of forex trading, you need to ensure you’re cut out for the job. A demo trading account is one of the most efficient ways to do this. As you practise and master your trading strategy, you’ll learn a lot about yourself, how you react to market pressures, and what you need to succeed. With this knowledge, you can confidently choose a funded trading account with a retail forex broker tailored to your trading needs.

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• Source: https://www.fintechnews.org/how-does-paper-trading-differ-from-trading-on-a-real-account/