What Is a Demo Account?

Demo Accounts Explained in Less Than 5 Minutes

Teacher typing on a computer.
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Demo accounts are where prospective investors can practice trading and learn systems before trading with real money. Many businesses offer these online programs for beginner investors to get a feel for what it’s like to trade on real markets—without the impending risk.

Demo accounts are attractive to many beginning investors and while they offer many benefits, in practice, some of the lessons learned through them may be problematic. Let’s take a look at how demo accounts work and what to be aware of as an individual investor.

Definition and Examples of a Demo Account

A demo (or demonstration) account is where beginning investors can test out strategies and learn how trading technology works, without facing the risks associated with the real markets. Users trade with fake money, and the demo account simulates what the returns would be in a real money account. High schools and colleges often use demo accounts to teach investing and compete against other schools in trading contests.

Demo accounts are popular among traders in stocks, currencies, and commodities, but aren’t as useful for long-term focused investors. The longer it takes to earn profits in an investment, the less useful the demo account is because the demonstration takes time away from compounding real money.

Demo accounts are also used by experienced traders to test out new strategies. Well-known hedge fund manager Ray Dalio talked about using demo accounts in his book, “Big Debt Crises.” Dalio went back through all the big calamities in U.S. market history and made trades day by day as the crisis unfolded to train himself to trade during future debt crises.

An example demo account is TD Ameritrade’s paperMoney. Using paperMoney, traders can modify the layout of the broker’s trading software (called thinkorswim) track and save historical returns, and use “do-overs” to retract completed trades.

Alternate names: paper trading, stock market simulator

How a Demo Account Works

Most online brokerages and Forex trading accounts offer demo accounts in some form. Other financial websites, such as Investopedia, offer stock market simulators as well.

Let’s go through how a typical platform works, using TDAmeritrade’s paperMoney as an example.

Step 1: Sign-Up for an Account

TD Ameritrade’s paperMoney has a short form to complete (existing TDAmeritrade users just need to download thinkorswim to use the program), including basic personal information, trading history, and which asset classes will be used.

In terms of personal information, most trading simulators and demo accounts require at least an email to use. Brokerage demo accounts require more information for a real money account once the demonstration is done.

Step 2: Download Software

The next step is to download the software associated with the demo account and modify the interface. Each trading strategy and asset class has its own metrics and technical indicators. This step of the process should be used to make sure the right indicators and metrics are available to you.

Step 3: Allocate Portfolio

Most trading platforms use a round number like $100,000 or $1 million as the demo portfolio amount. This allows trading in odd lots (100 shares) and for easy tracking of returns. It’s important to attempt to trade as closely to real life as possible.

Step 4: Trade

The final step of the process is to make trades. Some simulators, such as paperMoney, track your trading history and returns, and allow for do-over trades, while others allow for trading in past markets.

Pros and Cons of Demo Accounts

Demo accounts can be very useful for learning different trading strategies and softwares, but there are some downsides to the platforms as well.

Pros
  • Ability to learn the basics of investing

  • Can test new strategies

  • Explore new asset classes

Cons
  • Small sample size

  • False sense of confidence

  • Portfolio size

  • Lack of aggression

Pros Explained

  • Ability to learn the basics of investing: As a new investor, it’s better to make technical mistakes in paper trading than with real money. Each brokerage has its own proprietary trading software, which can be good practice for individual investors. It makes sense to take some time to learn how the software works and modify the interface.
  • Can test new strategies: As a beginner or seasoned trader, you have the ability to test new strategies without fear of risk through a demo account. A demo account allows the trader to test the strategy before using it with real money.
  • Explore new asset classes: While many traders start with stocks, commodities and Forex can also be very profitable. That doesn’t mean the same techniques work on all three asset classes. Experienced traders who want to branch into other asset classes can use demo accounts to test what works and what doesn’t.

Cons Explained

  • Small sample size: Demo accounts aren’t meant for trading through an entire market cycle, which means they’re time sensitive and only useful for whatever part of the cycle they were used during. This can make traders overconfident about techniques developed in the demo account that may not work a month or a year from now in live trading.
  • False sense of confidence: Trading in real-life markets comes with volatility and risk that does not exist in demo accounts. Generally, it’s impossible to generate the same emotional response to paper trading as live trading. Practice is great, but if and when you lose money in real life, you may not behave as rationally as you do when trading with a simulator. There’s a big difference between $50,000 of real cash being on the line and a few pixels on the screen changing.
  • Portfolio size: For many beginning traders, the portfolio or capital size in a demo account will be far larger than what an investor would really use when it comes time to trade in live markets. This is because you can choose how much capital you want to start out with. This makes it harder to establish good position size rules, as the fake amount typically does not equate to how much you’d really trade with.
  • Lack of aggression: Trading in a demo account versus real life is like playing a video game versus real life. You can get wiped out a thousand times in the game, but you can only get wiped out once in real life. Demo accounts can encourage over-aggressive trading and leverage use that can wipe out an account once real money is involved—and there are no do-over trades.

What It Means for Individual Investors

Demo accounts can be great tools for investors to practice delving into trading strategies and get a sense of how the market works. However, they are best used as training wheels to the real thing.

Investors should not become reliant on demo accounts to relay what really will happen when they start investing in real markets with real money. Remember: Simulated results often do not equate to actual trading results.

Key Takeaways

  • A demo account is where beginning (or experienced) investors can test out strategies and learn how trading technology works using fake money, without facing the risks associated with the real markets.
  • Trading in demo accounts is often referred to as paper trading.
  • Demo accounts are convenient ways to practice investing and test out new strategies, but there are downfalls to consistently using demo accounts, such as a false sense of confidence and a lack of aggression.