The Risks of Overtrading and How To Avoid It

Overtrading is one of the most common mistakes investors and traders make when they start. It reveals a lack of fundamental reasoning and a weak thesis behind each trade. Over the long run, it can severely impact your returns and your performance. Leaving your broker quite happy with all the additional commission he is able to generate. Although overtrading is a fairly common practice even among seasoned investors, it can be avoided. The consequences both in the short-term and long-term can be extremely detrimental.

What is overtrading? Definition and meaning

Overtrading is when an investor or trader constantly moves in and out of positions. There are several reasons that can be behind this, but the main one is inexperience. The lack of market experience can lead novice traders and investors to overthink, and move in and out of several positions. This constant buying and selling do very little for their portfolio except increase the brokers’ commission. 

An exception should be made however for short-term momentum traders. This type of trading often involves getting in and out of positions in the short term. Although it may seem like overtrading, the large amount of trading is directly related to the strategy itself.

Reasons for overtrading

There are several reasons that explain why investors and traders oftentimes overtrade. Although some of the reasons are more related to trading than investing it may affect both traders and investors. The main reason for overtrading is inexperience.

Inexperience

Inexperienced traders and investors often do not have sufficient knowledge to establish their thesis behind each trade or investment. This leads them to doubt themselves. Small price fluctuations can affect them deeply, and make them change their mind in regards to a specific trade. This causes the investor or trader to incur overtrading. Getting in and out of a position, trying to match the price fluctuations and overall direction of the market.

Overly focused on technical indicators

For traders and investors who derive most of their trade ideas through technical analysis, they may be too dependent on technical indicators. This means that their decision-making process is too dependent on technical indicators that may change abruptly. Causing them to exit a trade that they had already decided upon. Although technical indicators can provide valuable information, it is important to be aware that they may change suddenly.

Recouping losses

After a period of steep losses, a trader might feel that he has to regain the capital he lost. This is a terrible mindset to have, as it will force the trader to seek unexploitable trades. Positioning himself in situations where he might even lose more money. This is something to be aware of and to try to avoid at all costs.

Poor risk management

Being able to manage risk is among the most crucial aspects of investing and trading. A trader or investor with poor risk management may not see any problem with entering and exiting multiple trades during a short period of time. This is why having a tight risk control system is important to be profitable in the market.

Traders will trade

This is particularly common among traders, as opposed to investors. Traders are often driven by the gambling aspect of the markets. This is an extremely dangerous behavior that puts your capital at risk. Oftentimes traders will seek to put on trades that they are not entirely sure will play out, just for the sake of trading. This is also common among inexperienced traders, and it is important to keep in mind. Most of the stellar traders have just a handful of trading ideas throughout the year. Their analysis and conviction allow them to trade a few times, while at the same time generating spectacular returns. 

Consequences of overtrading

Overtrading has nefarious consequences on your portfolio, and on your returns. Some of the consequences include:

Increased commissions

Overtrading is great for brokers, but not so good for your own portfolio. Every time you put a trade and exit, the broker will be pocketing a commission. Overtrading only ensures that your broker will be charging you commissions on every trade. The more trades, the more the commission paid will be. The amount paid in commissions directly affects your returns, and therefore it undermines your performance.

Increased stress

Another consequence of overtrading is the increased amount of stress you expose yourself to. Entering and exiting multiple trades in a short period of time can be extremely exhausting and debilitating. Especially if you are also paying attention to the news, and technical indicators. Overall this can leave you in a state where you don't even know what you are trading or doing anymore.

Limits improvement

Overtrading also can limit your ability to improve your investment or trading skills. While you are focused on buying and selling multiple times a day, that time could be spent actually improving yourself so that you can become a better investor or trader. Overall it is a waste of time to be in and out of positions constantly. Focusing on learning, studying, and researching seems to be a far better use of your time. As it allows you to easily come up with trading or investing ideas.

How to avoid overtrading?

Trade journal 

First and foremost one of the best advice you can get is to keep a trading or investing journal with you at all times. This allows you to book down every trade you make, and write down the reasoning behind it. Put simply, you will have your thesis for each trade summarized, and your expected exit date. This is perhaps the most simple way for you to control each trade you make. It also allows you to easily see whether you are overtrading or not. 

Take some time off

Whether you are trading or investing it is important to sometimes take some time off away from the markets. This allows you to put your ideas in order, and to reflect upon your decision-making process. It might even be easier to analyze some mistakes you have made, and figure out ways of improving your process.

Define your process

No matter if you are investing or trading, having a process is important. This way you know exactly what to do before you place a trade, and you create boundaries for yourself. Allowing you to control yourself and your emotions in a much better way. It also allows you to manage your risk in a more practical, and enforceable way.

Do not chase losses

This needs to be repeated, do not chase losses, under any circumstance. This is perhaps the most damaging thing you can do to your own portfolio. Trading is not gambling, and thinking that you can easily recoup the money you have lost, will force you to chase bad trades after bad trades. It is also likely that any interpretation of a trade idea you might have, could be an exacerbated confirmation bias. Leading you to lose even more money.

Question yourself at all times

Being able to question yourself is incredibly important. Whether you have a certain thesis for a trade, or you are evaluating a previous trade, you have to be able to question your own reasoning. This ability allows you to see flaws in your own reasoning, and therefore you can improve your investment or trading process.

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