What is Overtrading?
Overtrading refers to excessive buying and selling of stocks by either a broker or an individual trader. Both are entirely different situations and have very different implications. An individual trader, whether working for themselves or employed on a trading desk by a financial firm, will have rules about how much risk they can take, including how many trades are appropriate for them to make. Once they have reached this limit, to continue trading is to do so unsoundly. While such behavior may be bad for the trader or bad for the firm, it is not regulated in any way by outside entities.
However, a broker overtrades when they excessively buy and sell stocks on the investor’s behalf merely with the outcome of increased commissions. Overtrading, also known as churning, is a prohibited practice under securities law. Investors can observe that their broker has been overtrading when the frequency of their trades becomes counterproductive to their investment objectives, driving commission costs consistently higher without observable results over time.
- Overtrading is a prohibited practice for brokers who advise investors and is regulated by the SEC.
- Brokers may be given subtle incentives to overtrade and investors should be wary of such practices.
- Individual professional traders also overtrade, but this activity is not regulated by the SEC.
- Individuals can greatly reduce the risk of overtrading by following best practices such as self-awareness and risk management.
Overtrading can occur for a number of reasons but all such reasons have the same outcome: poor performance of the investments at the expense of increased broker fees. One reason this practice has been known to occur comes about 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 can secure a certain allotment of a new security to their customers. Such incentives may not have the investors best interest in mind. 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. The SEC also looks into complaints of brokers who tend to put their own interests over their clients.
Individual traders usually overtrade after they have suffered a significant loss or a number of smaller losses in an usually long losing streak. To recoup their capital, or to seek “revenge” on the market after a string of losing trades, they may try harder to make up profits wherever they can, usually by increasing the size and frequency of their trades. While this practice often results in poor performance of the trader, the SEC does not regulate this kind of behavior because it is being done on the trader's own account.
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 churning 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
Overtrading in one's own account can only be curtailed by self-regulation. Below are some common forms of overtrading that investors may engage in, and begin informed about each can lead to better self-awareness.
The discretionary trader uses flexible position sizes and leverage and does not establish rules for changing size. Although such flexibility can have its advantages, more often that not, it proves to be the trader's downfall.
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. This behavior is classified as confirmation bias and usually leads to systemic losses over time.
Craving the action, traders often develop a "shotgun blast" approach, buying anything and everything they think might be good. A telltale sign of shotgun trading is multiple small positions open concurrently, none of which the trader has a specific plan for. 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.
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%.
- Be committed to risk management: traders who exercise strict position size management tend to outperform those who don't regardless of the systems or time frames being traded. Managing risk on individual trade will also diffuse the likelihood of a large draw down, in turn reducing the psychological pitfalls that come from such circumstances.