What Is Overtrading?
Let me explain overtrading to you directly: it refers to the excessive buying and selling of stocks by either a broker or an individual trader. These are entirely different situations with very different implications, and I'll break them down for you.
Key Takeaways
- Overtrading is a prohibited practice when brokers trade excessively for their client accounts in order to generate commission fees.
- Individual professional traders may also overtrade, but this type of 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.
Understanding Overtrading
As an individual trader, whether you're working for yourself or on a trading desk at a financial firm, you have rules about how much risk you can take, including how many trades are appropriate. Once you've reached this limit, continuing to trade is unsound. While this behavior might harm you or your firm, it's not regulated by outside entities.
However, if you're a broker, overtrading happens when you excessively buy and sell stocks on the investor’s behalf purely to generate commissions. This is also known as churning, and it's a prohibited practice under securities law. You can spot it as an investor when the frequency of trades becomes counterproductive to your investment objectives, driving commission costs higher without results over time.
Overtrading can occur for various reasons, but the outcome is always poor investment performance at the expense of increased broker fees. One common reason is when brokers are pressured to place newly issued securities underwritten by their firm's investment banking arm.
For example, each broker might receive a 10% bonus for securing a certain allotment of a new security to customers. Such incentives often don't prioritize your best interests as an investor. To protect yourself from overtrading or churning, consider a wrap account, which is managed for a flat rate rather than per-transaction commissions.
Individual traders like you usually overtrade after a significant loss or a streak of smaller losses. To recoup capital or get 'revenge' on the market, you might increase the size and frequency of trades. This often leads to poor performance, but the SEC doesn't regulate it since it's on your own account.
The Securities and Exchange Commission (SEC) defines overtrading or churning as excessive buying and selling in a customer’s account that the broker controls to generate increased commissions. Brokers who do this may breach SEC Rule 15c1-7 on manipulative and deceptive conduct.
The Financial Industry Regulatory Authority (FINRA) governs overtrading under rule 2111, and the New York Stock Exchange (NYSE) prohibits it under Rule 408(c). If you believe you're a victim of churning, file a complaint with the SEC or FINRA.
Types of Overtrading Among Investors
Overtrading in your own account can only be controlled through self-regulation. I'll describe some common forms so you can build better self-awareness.
Discretionary overtrading happens when you use flexible position sizes and leverage without rules for changes. While flexibility can help, it often leads to your downfall.
Technical overtrading occurs when you're new to indicators and use them to justify predetermined trades. This is confirmation bias, where you seek backing for decisions, leading to systemic losses over time.
Shotgun overtrading is when you crave action and take a 'shotgun blast' approach, buying anything that seems good. Signs include multiple small positions without plans, and you'll struggle to explain why you made specific trades.
Preventing Overtrading
You can take steps to prevent overtrading, and I'll outline them directly.
Exercise self-awareness: If you're aware you might be overtrading, assess your activity frequently. Patterns like increasing trades each month signal a problem.
Take a break: Overtrading often stems from feeling you must trade, leading to suboptimal losses. Time off lets you reassess strategies against your objectives.
Create rules: Set rules for entering trades using technical or fundamental analysis to avoid deviating from your plan. For instance, only trade if the 50-day moving average crosses above the 200-day and the stock yields over 3%.
Be committed to risk management: Strict position sizing helps you outperform others. It reduces large drawdowns and the psychological issues that follow.
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