Trading Tip 16: Paper Trading Resuts vs. Real Trading Results

Whether you purchased a trading strategy or developed your own system or trading ideas:
You should *always* paper trade the new system first.

There are several reasons why paper trading can save you thousands of dollars. Trading your strategy on a paper trading account is risk-less, and it will show you pretty fast whether your trading strategy will be profitable or now.

The big question is: Will you achieve similar results when trading real money?

You already know that there’s a difference between hypothetical and real trading results for various reasons.
(see http://www.rockwelltrading.com/rockwell-trading-articles/Whats-the-deal-with-hypothetical-results.htm).

But what about paper trading results?

Answer: Yes, you will achieve similar results, but they won’t be exactly the same.

Here’s why:
Every strategy uses either stop, market, market-if-touched or limit orders.
To date no paper trading account can exactly determine at what price you would have been filled.

Let’s discuss this topic using limit orders as an example:
Limit orders are filled according to the FIFO-principle: First In – First Out.
Example: If you and I are placing a limit order at exactly the same price, but you are placing it 1 second before I do, then YOUR limit order is filled first.

If there are more sellers than buyers at a certain price point, then some limit orders are not getting filled.
And of course MARKET-orders have priority, i.e. first all market orders are getting filled and THEN limit-orders according to the FIFO-principle.

As you can see, there are five variables that influence the fill of a limit order:

• Number of buyers at a certain price
• Number of sellers
• Number of traders using market orders
• Number of traders using limit orders
• Speed of transferring your order, which determines your place in the queue

All these factors make it impossible to simulate whether you would have been filled at a certain price or not.

The currently available software packages try to simulate a fill in one of the following three ways:

• They assume that a limit order is filled if prices are touching the specified limit price.
• They assume that a limit order is filled if prices are trading THROUGH the limit price.
• They assume that a limit order is filled when prices touch the limit price X times

None of these approaches correctly reflects the “real” fill of limit orders.

Based on the approach that your paper trading account chooses, you will achieve more or less the same results.
Option 1 is the least accurate,
Option 2 is the most conservative (but not accurate either),
and Option 3 usually reflects the “real” market behavior best (based on the settings).

Using a software that uses Option 3 to determine fills ensures that your real trading results
will be similar to your paper trading results, but not exactly the same.

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