What is Overtrading
Overtrading refers to excessive buying and selling of stocks by either a broker or an investor. A broker overtrades when they excessively buy and sell stocks on the investor’s behalf to increase commissions. Overtrading, also known as churning, is a prohibited practice under securities law. Investors overtrade when the frequency of their trades becomes counterproductive to their investment objectives.
Overtrading may also refer to a situation in which a company is growing its sales faster than it can finance them. A business that overtrades can become insolvent as it tries to accommodate customers who wish to purchase their products. This ultimately leads to not being able to pay for the financing costs used to produce the goods.
BREAKING DOWN Overtrading
Overtrading has been known to arise when brokers are pressured to place newly issued securities underwritten by a firm's investment banking arm. For example, each broker may receive a 10% bonus if they allocate a certain allotment of a new security to their customers. Investors can protect themselves from overtrading (churning) through a wrap account - a type of account managed for a flat rate rather than charging commission on every transaction.
Investors may overtrade after they have suffered a significant loss to recoup their capital, or to seek “revenge” on the market after a string of losing trades.
Regulation of Overtrading
The Securities and Exchange Commission (SEC) defines overtrading (churning) as excessive buying and selling in a customer’s account that the broker controls to generate increased commissions. Brokers who overtrade may be in breach of SEC Rule 15c1-7 that governs manipulative and deceptive conduct. The Financial Industry Regulatory Authority (FINRA) governs overtrading under rule 2111 and the New York Stock Exchange (NYSE) prohibits the practice under Rule 408(c). Investors who believe they are a victim of churching can file a complaint with either the SEC or FINRA. (For further reading, see: How to Tell if a Broker is Churning Your Account.)
Types of Overtrading Among Investors
Below are some common forms of overtrading that investors may engage in. Each manifests itself differently, and to varying degrees, depending on whether the trader's style is discretionary or technical.
The discretionary trader uses non-quantifiable data - such as advice from a broker or perceived expert, news reports, personal preferences, observations and intuition - to determine entry and exit points. Position sizes and leverage are flexible. Although such flexibility can have its advantages, more often that not, it proves to be the trader's downfall. Discretionary traders often find inactivity the hardest part of trading. As a result, they're prepared to embrace any development that will allow another trade. This impulsive behavior, in fact, isn't trading at all - it's gambling. And just like in the casino, the odds are not in the overtrader's favor.
Traders new to technical indicators often use them as justification for making a predetermined trade. They have already decided what position to take and then look for indicators that will back up their decision, allowing them to feel more comfortable. They then develop rules, learn more indicators and devise a system. If the system is right more often than not, they believe they've finally beaten the odds, and may reason they'll improve their profitability with increased trading. Unfortunately, this can have severe consequences for traders' returns.
Hair-trigger trading is enhanced by electronic trading, which makes it possible to open or close a position within seconds of the idea forming in the trader's mind. If a trade moves slightly against the trader, it is sold immediately; if a market pundit shouts out a tip, a position can be opened before the ad break. Hair-trigger trading is easy to identify. Does the trader have many small losses and few wins? Looking back over trade logs, did the trader overestimate his wins and conveniently dismiss his losses? Were trades exited almost as soon as they were entered? Are some positions continuously opened and closed? These are all classic signs of hair-trigger trading.
Craving the action, traders often develop a "shotgun blast" approach, buying anything and everything they think might be good. They might justify this with the argument that diversification lowers risk, but this logic is flawed. First, true diversity is spread over multiple asset classes. Second, multiple bad trades will never be better than just a few. If a trader has isolated a promising trade, concentrating capital on that trade makes the most sense. A telltale sign of shotgun trading is multiple small positions open concurrently. But an even more firm diagnosis can be made by reviewing trade history and then asking why a particular trade was made at the time. A shotgun trader will struggle to provide a specific answer to that question.
Bandwagon trading is a deliberate attempt by discretionary traders to piggyback or mimic those they consider to be "in the know." This ploy is fundamentally flawed for two reasons. First, even experts don't have all the answers, and they can't predict the future. Their experience and talents are merely two factors among many. The second reason is that when many traders follow the same path - led by a loudmouthed pundit, a biased stakeholder or the results of many technicians inadvertently using the same indicators - the initial move may degenerate rapidly. This is a basic economic principle: Competition reduces margins. In trading, this manifests itself when bandwagon traders compete to exit identical positions as early as possible, often causing a price stall or reverse. To make matters worse, novice traders are most likely to trade on the bandwagon and most likely to exit prematurely, exacerbating this effect.
Movers and Shakers
The market is not always smooth sailing. Instead of large trending moves, it sometimes shakes about in a choppy, sideways direction. Many novice traders will overtrade by assuming that minor market corrections are the beginning of the next trend. They'll jump in and out as the expected trend forms and fails. They may even compound the situation by doubling their positions.
This can be the most destructive form of overtrading. Confident that the reversal is imminent, the trader doubles the size of a losing trade in the belief that he or she has averaged down to a better entry price and will therefore make a bigger profit on the move. Most often, however, this just increases losses. Successful traders, on the other hand, sometimes add to winning trades - not losing ones - and are quite content to sit out the market, waiting for the right conditions under which to re-enter. In contrast, an unskilled trader, will be continuously drawn back in.
There are a few steps traders can take to help prevent overtrading:
- Exercise self awareness: Investors who are aware they may be overtrading can take actions to prevent it from occurring. Frequent assessments of trading activity can reveal patterns that suggest an investor may be overtrading. For instance, a progressive increase in the number of trades each month may be a telltale sign of the problem.
- Take a break: Overtrading may be caused by investors feeling as though they have to make a trade. This often results in less-than-optimal trades being taken that result in a loss. Taking time off from trading allows investors to reassess their trading strategies and ensure they fit their overall investment objectives.
- Create rules: Adding rules to enter a trade can prevent investors from placing orders that deviate from their trading plan. Rules could be created using technical or fundamental analysis, or a combination of both. For example, an investor might introduce a rule that only allows them to take a trade if the 50-day moving average has recently crossed above the 200-day moving average and the stock pays a yield greater than 3%.