Complete comparison of backtesting vs paper trading. Learn when to use each method, pros/cons, and the optimal workflow for strategy validation.
Test on historical data
Test in real-time
Backtesting runs your trading strategy on historical market data to see how it would have performed. Test 10 years of data in seconds, across thousands of trades, to validate strategy logic.
Optimize on 2014-2018, test on 2019. Then optimize on 2015-2019, test on 2020. Prevents overfitting.
Add 0.1-0.3% per trade for commissions and slippage. Many strategies fail after costs.
If strategy only works on SPY but fails on QQQ/IWM, it's overfit to SPY.
A strategy with 20% returns but 50% drawdowns is unusable. Max 25% drawdown recommended.
Paper trading simulates live trading with fake money in real market conditions. You place orders, get real-time fills, track P&L, but no actual capital at risk. Tests execution and psychology.
Start with realistic capital ($10K-50K). Use same position sizes you'll use live. Take it seriously.
Need 30-50 trades minimum. 1 month isn't enough. 3-6 months ideal.
Log entry price, exit price, P&L, reason for trade, emotions. Review weekly.
Practice order types (limit, stop, trailing stop). Test position sizing. Verify risk management works.
| Metric | Good | Red Flag |
|---|---|---|
| Backtest sample | 500-2,000 trades; 5-10+ years mixed regimes | <200 trades or only bull markets |
| Backtest quality | PF 1.5-2.5, max DD <25%, realistic costs | PF >3.0 with tiny sample or no costs |
| Paper trade duration | 4-12 weeks; 50-200 paper trades | Stopped after a few wins/losses |
| Forward vs backtest gap | Paper PF/WR within 10-20% of backtest | Paper results collapse (>30% worse) |
| Execution realism | Slippage/fees modeled; live venue data | Assumed mid-price fills; no cost model |
Best results come from using both methods in sequence
Test 10-20 strategy variations. Eliminate losers. Optimize survivors.
Test survivors in live conditions. Validate execution and discipline.
Start with 10-20% of target capital. Scale up gradually.
• Stage 1 (Backtest): 80% of strategies eliminated (only 2-3 of 10-20 pass)
• Stage 2 (Paper Trade): 50% eliminated (1 of 2-3 survivors)
• Stage 3 (Live): 70% succeed if paper trading was successful
Final Success Rate: 5-10% of original ideas reach profitable live trading
| Factor | Backtesting | Paper Trading |
|---|---|---|
| Speed | ⚡ 10 years in 10 seconds | 🐌 3 months takes 3 months |
| Cost | 💰 $0-50/month | 💰 Free (broker) |
| Data Available | ✅ 10-20 years | ⚠️ Current conditions only |
| Realism | ⚠️ Simulated execution | ✅ Real-time fills |
| Psychology | ❌ Can't test emotions | ✅ Tests discipline |
| Sample Size | ✅ 100s-1000s of trades | ⚠️ 20-60 trades typically |
| Optimization | ✅ Test 1000s of variations | ❌ Too slow for optimization |
| Best For | Strategy development, initial validation | Final validation, execution testing |
Backtesting tests strategies on historical data (fast, cheap, years of data). Paper trading tests strategies in real-time with simulated money (slow, realistic, current conditions). Backtesting: 10 years tested in 10 seconds. Paper trading: 3 months takes 3 months. Both validate strategy logic, but test different aspects.
Always backtest first. Backtesting quickly eliminates bad strategies (80% fail). Paper trading is too slow to test dozens of ideas. Optimal workflow: 1) Backtest 10 strategies (eliminate 8), 2) Paper trade 2 survivors (1-3 months), 3) Live trade winner with small capital. This saves months of wasted time.
Neither is "better" - they serve different purposes. Backtesting: Fast, tests historical performance, cheap, 10+ years of data. Paper trading: Slow, tests real-time execution, tests psychology, current conditions. Best approach: Use both. Backtest first (speed), then paper trade (validation). 70% of backtest winners also succeed in paper trading.