Just about every broker offers a demo trading account so that you can practice trading Forex before committing real money. If you have been studying the Forex market for a long time and believe you have a feel for the rhythm of the market, a demo account seems like a waste of time, especially if you miss an opportunity where you were 100% sure of the outcome and that outcome did, in fact, occur.
Brokers say you should practice on a demo account to:
- Avoid losing money on bad trades.
- Avoid losing on badly placed trades.
- Learn their software.
- Learn how to reconcile your trades for accounting and tax purposes.
Before choosing a broker, you should look at several, because they each feature one aspect or another. What is more important to you — the chart, the quotes, the news, information on your existing trades, or your account balance? Some brokerage platforms are really complicated and would take hours and hours of practice for you to become comfortable using them (TD Ameritrade Think or Swim, for example — a thing of beauty but terribly complex).
The real reason to practice trading before you commit any capital is to go on an honest journey of self-discovery. Not everyone really wants to do this. You may find out that you have an itchy trigger finger and a preference for making impulsive trades, or that you suffer from ”analysis paralysis” — you become overwhelmed by conflicting chart interpretations and news analysis and cannot make any trades at all.
Those are two extremes. The most frequently discovered self-knowledge is that you do not have a trading system that incorporates money management rules.
Keep in mind that the only reason to trade is to make a profit. It is not to prove that your theories about the universe are correct. To make a profit, you need a consistent, systematic set of trading rules that you follow in a disciplined manner and that are designed upfront to generate more profit than losses.
The demo account has a really big advantage over back-testing — you can see live, real-time slippage. Slippage refers to the difference between the price you seek to enter or exit, and the actual price available in the market. Let’s say you choose to enter-on-open and the open is 1.4000. In a back-test, software will take that number as the actual entry. Nevertheless, in real trading, you may get filled at 1.4004. Those four points may seem minor on any single trade but now consider that your stop may get hit at another four points worse than your order. Now you have “lost” eight points. A key issue in turbulent markets can be the price jumping over your stop and you get filled at 30 points under your stop. Now you have lost 34 points.
This is why back-tested results are always better than actual or demo-trading results. Do not blame the system vendor — it is the nature of the beast and an inevitable part of the process. When you see a hypothetical track record of a trading system from a vendor, you need to check how much slippage would have reduced total profitability. At a guess, slippage cuts 10-20% from the reported P&L. The system may still be a valuable one and worth your consideration — just be realistic about your expectations. If the system has delivered 40% returns, you should expect the real percentage gain you will get would always be less than 40%.
The Past Is Not the Future
Whether you build or buy a trading system, be aware that the profitability you see for the past will not be the profitability you see going forward. This is because market conditions change faster than system adaptability. A trading system that relies on trendedness will do badly in a range-trading market, and a system that does well in range-trading conditions will not do as well as a trending system in a trending market. One of the biggest challenges in technical system-building, if not the biggest challenge, is to differentiate between trending and range-trading. Every software-based trading system is based on one or the other condition, and those that try to do both almost always have a strong component of human judgment injected, called “discretion.”
Expert advisors do not always disclose in clear language what approach they are taking, whether trend-following or range-trading. By using a demo account, you can figure it out for yourself.
The Acid Test — Audit Your Results
Whether you buy or build a trading system, you need to know whether your stop-loss and profit targets deliver your desired gain/loss ratios. The only way to know this is with a live account, and demo accounts are a good way to get the information. Say, for example, you always set your stop at 25 points and your target at 45 points. These points reflect the dollar amount of loss you can tolerate and the amount of gain you are seeking given the loss.
Your audit should measure for at least 50 trades (and 100 trades would be better):
- Gain/loss ratio in terms of number of trades
- Gain/loss ratio in terms of dollar gain/loss
Most people stop at this point. However, you should aim to refine your stops and targets systematically. You should test whether either ratio would be improved by changing the stop to 20 or 30 points, or by changing the target to 40 or 50 points. Remember, though, that if you are reducing or enlarging one or the other or both, you are assuming that the conditions you had during the sample period of the 50 or 100 trades will persist into the future. Enlarging a profit target means you had a wider average daily range than you had assumed when you set the target in the first place, and if you keep it enlarged in the upcoming period, you have reason to believe the wider range will persist.
If you are building or buying a trading system, a demo account is essential to test whether the trading system actually works. You can buy trading advice in many different ways, including buy/sell recommendations on a spreadsheet. You can follow some particularly insightful and astute fellow trader — but unless you can replicate the results, it is just hot air. Some brokers offer trading systems from specific “expert advisors” and they execute the trades on your behalf (for a fee). Expert advisors are also available on the MetaTrader platform.
Trading on a demo account is always a good idea but it does lack one important thing — the gut-wrenching, sweat-dripping exuberance over a real cash gain and a real cash loss. You are missing out on the emotion. We build trading systems to curtail emotion and we have money management rules to avoid surprises, but the market delivers emotion anyway. Trading a demo account is to real trading as driving a mini-Cooper in a parking lot is to driving a Ferrari at top speed along a mountain road.