Overtrading: everything you need to know
Traders have to think on their feet when buying and selling assets. But if they don’t stick to their trading plan, it can lead to unsound practices such as financial overtrading. Let’s explore the risks and effects of overtrading.
What is overtrading?
Overtrading is the excessive buying or selling of financial instruments, also known as churning. In other words, having too many open positions or using a disproportionate amount of money on a single trade. There are no laws or regulations against overtrading for individual traders, but it can be damaging to your portfolio. For trading brokers, overtrading may hold serious consequences, as they are regulated bodies.
Your trading style is an important component of trading volume. This means that your preferred style should guide you in terms of whether you are overtrading or undertrading. For example, if you’re a position trader, and you are trading once a day, you are likely to be overtrading.
Overtrading vs undertrading: what’s the difference?
Overtrading is the opposite of undertrading. Undertrading typically means there is little or no trading activity even when there are opportunities to trade. When traders don’t use their funds for an extended period, hold very small positions, or have very strict entry conditions, they may be at risk of undertrading.
The biggest cause of undertrading is the fear of losing money. But, if you don’t trade, you could miss out on the right opportunities. Traders who have not set up a trading plan, and just watch stocks as they go, are also at risk of undertrading.
Causes of overtrading
Overtrading is caused when a trader or trading broker does not adhere to the limits of their strategy. They feel tempted to increase their trading frequency without consulting their trading plan, which can lead to poor results. To prevent overtrading, you can amend your trading plan at any time, making it more restrictive – adding strict entry and exit criteria.
Overtrading is also caused by emotions such as:
- Fear: individual traders often overtrade in an attempt to make up for a loss
- Excitement: traders can be tempted to open positions without analysis when the markets are moving quickly
- Greed: when traders are making a profit, they want to make even more money
How to avoid overtrading
To avoid overtrading, it is best to have a comprehensive trading plan and risk management strategy in place. There are also other measures you can take, namely:
- Avoid emotional trading: distinguish between rational and emotional trading decisions, and back up your decisions with clear analysis
- Diversify your portfolio: if you often have more than one position open, you can help minimize risk by spreading your investment across asset classes
- Only use what you have: decide how much you want to risk, but never trade using more capital than you can afford to lose
When it comes to your trading plan, elaborate on your goals and motivation, the time and money you have available, risk management and your market knowledge.
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Goals and motivation
Outline what drives you to trade. Is it for potential profits? Or is it simply to learn more about how financial markets work? It’s important to not only write down why you want to be a trader, but also what type of trader you want to be. There are four common trading styles, namely scalping, day trading, swing trading and position trading.
Finally, you should log your daily, weekly, monthly and yearly targets.
Time and money
Decide how much time and money you want to commit to trading. Remember to factor in the time you’ll need to prepare, learn more about the markets, analyze financial information and practice on a demo account. Then, decide how much of your money you can dedicate to trading. Never risk more than you can afford to lose.
Risk management
Decide how much risk you are prepared to take on. All financial assets carry risk, but it is up to you how aggressive your risk strategy will be. Risk management includes outlining your preferred stops, limits and risk-reward ratio.
Market knowledge
Before you start trading, it is very important that you do your research on the markets and write down your learnings. Evaluate your expertise and interest before you jump into trading and keep a trading diary to learn from your past mistakes.
Overtrading: risk management
Managing the risk of overtrading starts with a trading plan. Regardless of your level of experience, the type of trader that you are, or the money you have to spend, you need a well-thought-out trading plan. Once you have this blueprint, you will be able to assess whether you are overtrading (or undertrading).
As part of your trading plan, you need a risk management strategy. This will include the rules and measures you put in place to ensure the impact of making a mistake is manageable. There are three main types of risk in trading:
- Market risk: the possibility that you may suffer a loss due to movements in market prices, caused by factors such as interest rates and exchange rates
- Liquidity risk: the risk that you can’t buy or sell an asset quickly enough to prevent a loss
- Systemic risk: the chance that the entire financial system might be affected by an event
There are two practical risk-management techniques you can use to make sure you’re not overtrading:
Calculate your maximum risk per trade
Choosing how much to risk per trade is a personal choice. It can be anything from 1%, and up to 10% for traders who can take on a lot of risk. But if you risk as much as 10%, it could only take five trades to lose 50% of your trading capital, which is why it is normally advisable to use a lower percentage. You have to make sure your risk percentage is sustainable and that you can still reach your trading goals with the amount of risk that you’re taking on.
Work out your preferred risk-reward ratio
To find the risk-reward ratio on a trade, compare the amount of money you're risking to the potential gain. So, if your maximum potential loss on a trade is $200 and the maximum potential gain is $600, then the risk vs reward ratio is 1:3. Many traders like to stick to a risk-reward ratio of 1:3 or better.
Overtrading summed up
- Overtrading is the excessive buying or selling of stocks. It can mean having too many open positions or using a disproportionate amount of money in a single trade
- The opposite of overtrading is undertrading. This typically means there is little or no trading activity
- Overtrading is caused when the limits of a trading strategy are not adhered to. It can also be caused by emotions such as fear and greed
- To avoid overtrading, it is best to have a comprehensive trading plan and risk management strategy in place
- There are two practical risk-management techniques you can use to make sure you’re not overtrading – calculating your preferred maximum risk per trade, as well as the risk-reward ratio
Now that you know more about the importance of your strategy and trading frequency, you can start trading. Open a live trading account if you’re ready to start today, or open a risk-free demo account if you’d like more practice.
This information has been prepared by tastyfx, a trading name of tastyfx LLC. This material does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. You should not treat any opinion expressed in this material as a specific inducement to make any investment or follow any strategy, but only as an expression of opinion. This material does not consider your investment objectives, financial situation or needs and is not intended as recommendations appropriate for you. No representation or warranty is given as to the accuracy or completeness of the above information. tastyfx accepts no responsibility for any use that may be made of these comments and for any consequences that result. See our Summary Conflicts Policy, available on our website.
