Paper trading or mock trading as many would like to term it is very popular amongst beginners. Here a beginner trades various financial instruments without real money. He buys and sells a particular instrument in a particular lot size using a pen and paper and watches how his trade unfolds. He then makes note of his virtual profit or virtual loss. He repeats this over and over again to decide which trading system works for him and what should be avoided. More often than not, the paper trader always makes a fortune on paper and begins to believe that he has identified the perfect trading system and has found the key to success.
This, however, is very far away from the real truth as the most important aspect of trading is completely missing from his mock trades. This missing factor is emotions.
When a trader trades on paper he is completely at ease as he has nothing really to lose. There is no real money involved and hence no real fear of loss. Also, his gains are virtual and offer him a false sense of victory and gratification which completely blinds him to any drawbacks his trading system may possess.
Such a virtual trader, when he enters the real world with real money is soon washed out by the harsh realities and challenges the real markets throw at him. He is left stunned when actual losses do hit him and more often than not is left with a depleted account and no clue of what happened. He cannot comprehend why his trading system, which worked so effortlessly on paper, has become such an unfathomable disaster.
Real trading involves real money, real risk, and real rewards. It allows a trader to feel the joys of his victory and the pain of his losses. When the trader is involved in a real trade, not only is he at genuine risk of losing his money but is also at the end of his wits trying to figure out a way to exit his position with a minimum loss. On the positive side, if his trade is moving in his favor he is being constantly challenged by the market and is trying hard to decide if he needs to book profits, hang on or lock partial profits. From the time he enters the trade to the time he closes it, he goes through a lot of emotions and is kept on his toes by the markets. This situation is completely missing in paper trading.
Paper trading may be used to finalize a system or observe market movements but should never be used for making a trading system or to test its accuracy.
A new trader may thus decide how he should go about taking his trade using paper and pencil but once done, he should start trading with real money to test his plan. He must use risk management techniques to minimize his losses. He may start with a very small capital and gradually increase his position size after successfully implementing his strategy.
To put it deftly, swimming is learned by jumping in the water with a float and not by sitting at the edge of the swimming pool with a pencil and paper!