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 they try 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.)

Preventing Overtrading

  • Self Awareness: Investors who are aware they may be overtrading can take actions to prevent it 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 the need they have to make a trade. This often results in less the 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 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%.

           (For more, see: Tips for Avoiding Excessive Trading.)

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