Trading with simulators is very appealing to novice investors and beginner traders but it must be noted that simulated trading has its advantages and disadvantages. There are numerous excellent and very realistic simulator packages available for traders out there to "paper trade" electronically. Some trading brokers like Interactive Brokers (IB) even provide simulators (IB TWS Demo or PaperTrader) to let beginners take a "test-drive" of their trading front-end systems before going live. IB’s PaperTrader has the exact look and feel as the real thing except being tagged with a red "Simulated Trading" band on all windows.

Advantages of Simulated Trading/Paper Trading

The main advantage of using a simulator is that you get a chance to familiarize yourself with the software you intend to use for trading. It is imperative for novice traders to spend some time knowing where all the controls are for e.g. where the buy and sell hotkeys are, how to track trading and portfolio positions and price movements and how to adjust different views and create technical analysis charts. Doing this diligently will prevent fumbling around with the controls when you are trading "live".

Disadvantages of Simulated Trading/Paper Trading

Traders have to seriously pay extra attention to the disadvantages of simulated trading. The main disadvantages include the psychological reaction to profits and losses and unrealistic order execution entry & exit points.

Psychological Reaction to Profits and Losses

In simulated trading, there is a sort of physical detachment from reality and hence no psychological reaction to profits and losses. Cutting a loss that does net affect your account is easy. In fact, if you are showing losses, it is simple to restart the software and start from zero. Conversely, a simulator is also unable to test your reaction to making real money, which may lead to over-exuberance and over confidence. Either way, the simulator will never be able to test your psychology and discipline, which are deciding factors in your profitability or lack thereof. If you want to test those, test them in the real market with real risk exposure, and compensate by limiting the size of your trades.

Unrealistic Order Execution Entry & Exit Points

The other disadvantage to be wary of is unrealistic and false order execution. A penny here and a quarter there in inaccurate order execution and slippage will add up to alot of dollars. Primarily, a trading simulator (or paper trading, in general) will test your ability to pick correct direction. Order execution skills, like discipline and psychology, can only be realistically tested in the open market and not on the simulator. Use the simulator to familiarize yourself with the software, reading the tape and picking direction. Use this time to explain to yourself, in retrospect, how and why you would have made and lost money. If you have "made" money on the simulator, do not let it lull you into thinking the same will happen in the real market. This can be dangerous as it can cause you to be overconfident and enter the market with your guard down.