A paper trade occurs when a person essentially pretends he has invested a sum of money in a given stock or investment. Paper trading is used by individuals who want to learn about trading in various types of investments — must commonly stocks — without actually risking any money. It allows an individual to experiment with an investing method or strategy without taking the risk of losing his actual funds.
When a person paper trades, he creates a written record of a financial transaction or investment that does not actually exist. For example, a person who wants to test out his ability to select stocks may look at two given stocks he is interested in. He can record the price of a stock on the day he would have bought it, and record what it would have cost him to have purchased 100 shares of that stock at the price on that date. This is essentially a paper trade, as he is buying 100 shares of the stock on paper. He can then watch the stock as it rises and falls and determine what he would have made had he purchased the stock.
Most investments go up or down according to various factors that impact the value of the investment. For example, a stock price can rise based on how the company does and on economic conditions in the stock market as a whole. When investing actual money in a stock, those ups and downs affect a person's financial situation, because he gains or loses money as a result of his ownership of the stock.
Since trading stocks or purchasing other investments can be complicated, many people use paper trading as a means of determining whether they can understand investing and pick wise investments before investing real money. A person can track his paper trade profits and losses over time to determine if he knows how to invest. New investment strategies, such as investing in options or investing in a foreign exchange currency market, can also be tracked by making a paper trade or series of paper trades and observing the performance of those trades.
It is possible to make a paper trade using a notebook and a pen to record "purchases" and changes in the value of the purchased investment. There are also programs online that allow a person to create a practice portfolio as if it were a real portfolio. The online programs automatically track the value of the investments, making paper trading easier than manually keeping track of trades.