Understanding Overtrading
Overtrading refers to the excessive buying and selling of stocks by either a broker or an individual trader. Though carried out in different contexts, both forms of overtrading can have serious implications.
Key Takeaways
- Overtrading by brokers, known as churning, aims to generate excessive commission fees and is prohibited under securities law.
- Individual traders can also engage in overtrading due to psychological biases and lack of risk management, but this activity is generally unregulated.
- Best practices in risk management and self-awareness can greatly reduce the incidence of overtrading among individual traders.
Understanding Broker Overtrading
When brokers overtrade, they excessively buy and sell stocks on the investor’s behalf just to earn commission fees. This practice, known as churning, is strictly illegal. An investor may notice overtrading through a rise in unproductive trades that result in higher commission costs. One common cause is the pressure brokers face to place newly issued securities underwritten by their firm’s investment banking arm. Incentives for achieving sales targets often do not align with the best interests of the investor.
Investors can guard against this by opting for a wrap account—a managed account charged at a flat rate, which can help mitigate unnecessary trading activities.
The Habit of Individual Overtrading
Individual traders often overtrade after experiencing significant losses or long losing streaks. The increased size and frequency of trades are usually attempts to recover lost capital. This form of overtrading often leads to poor investment performance, yet it remains unregulated since the trader is acting on their own account.
Regulatory Framework
Overtrading, or churning, when conducted by brokers falls under the oversight of regulatory bodies such as the Securities and Exchange Commission (SEC). SEC Rule 15c1-7 governs manipulative and deceptive conduct, making overtrading a punishable offense. In addition, organizations like the Financial Industry Regulatory Authority (FINRA) and the New York Stock Exchange (NYSE) have rules that prohibit this practice. Investors can file complaints with either the SEC or FINRA if they believe they are victims of churning.
Types of Overtrading Among Investors
Discretionary Overtrading
This occurs when traders use flexible position sizes and leverage without established rules, often leading to financial downfall despite its apparent flexibility.
Technical Overtrading
New traders may misuse technical indicators to justify predetermined trades, falling into the trap of confirmation bias. This often results in chronic losses over time.
Shotgun Overtrading
Traders using a “shotgun blast” approach buy anything they think might be profitable, ending up with multiple small, poorly planned positions. Reviewing trade history can reveal this behavior, typically characterized by an inability to explain the rationale for each trade.
Preventing Overtrading
Exercise Self-awareness
Traders should frequently assess their trading activity to identify patterns indicating overtrading, such as a rising number of trades each month.
Take Breaks
A feeling of compulsion to trade often results in suboptimal decisions. Taking breaks helps traders reassess and align their actions with their investment objectives.
Create Rules
Incorporate rules grounded in technical or fundamental analysis to avoid deviating from the trading plan. For example, trade only if certain moving average criteria are met and the stock provides a suitable yield.
Commit to Risk Management
Traders who strictly manage position sizes typically outperform those who don’t, regardless of their trading system. Effective risk management minimizes large drawdowns and the psychological challenges that accompany such scenarios.
Related Terms: churning, leverage, confirmation bias, SEC regulations, investment strategy, fundamental analysis.
