4 Reasons to Try Paper Trading

The term "paper trading" harks back to a time before computers, when aspiring traders practiced their trades on paper before risking money in live markets. These days, it's much more sophisticated thanks to online tools that replicate the live trading experience (see "How to start paper trading at Schwab").

Here are four situations where traders might consider simulated trading before putting actual dollars in play.

An effective way to learn is by doing, but learning often means making mistakes, which can be a deterrent to trading when real money is at stake. With paper trading, newcomers can dip their toes into the markets and start to test strategies without the threat of losses.

Even more seasoned traders may benefit from a virtual experience. For example, maybe a fundamental trader wants to dabble in technical charts, or vice versa. Or a trader with substantial experience trading stocks with strong momentum wants to hone their defensive skills in case the market takes a turn. Or perhaps a trader learned about a new trading approach via Schwab's YouTube tutorials and wants to try it out. Whatever the case may be, paper trading can help traders grow and refine their trading skill set.

Sometimes a losing streak can seem hard to break. Paper trading lets traders tweak their approach through virtual trial and error, which may help them reenter the market with more confidence.

That said, be mindful of the emotional differences between live and simulated trading. Maybe a slump was exacerbated in the heat of the moment, which can cause a trader to act in ways counter to their goals. While paper trading can't truly replicate the intensity of having real money on the line, the more a trader practices, the greater their ability to manage knee-jerk reactions in actual high-stakes situations. It can also help develop emotional discipline by exposing a trader to certain market situations where they can gain experience without the risk.

Paper trading can also help a trader learn the key functions of a new trading platform so they're not scrambling to navigate an unfamiliar tool in the thick of the action.

Whatever the motivation for trading in a simulated environment, here are a couple of considerations:

• Treat it like the real thing: If a trader wants to get the most out of paper trading, it's important to give it their full attention. Follow a trading plan just as one would with a real trade: Doing due diligence, setting usual entry and exit points, monitoring positions, and not taking on more risk than normal just because it's "play" money. The goal of practice is improvement, but any bad habits a trader picks up could sneak into a real trading experience—and potentially risking their portfolio.
• Scrutinize performance: One way a trader can improve their craft is by understanding the cause of successes and failures. A good streak or a series of losses may be traced back to a deliberate change in behavior. A trader may want to focus on racking up some wins and having a strong gain/loss ratio in the paper environment before trading a new strategy or method with real money.

Although perfection is an illusion—at least when it comes to trading—practice is key to improving techniques. Exercising paper trading with a real commitment can help a trader learn valuable skills.