Overtrading: what is it and how to avoid it

One of the main problems that traders, especially beginners, have to face is overtrading. Risking falling into excessive trading is very common but can be avoided with a few precautions.

Let’s start with the definition of overtrading. “Overtrading”, also called “churning” or “overexposure”, means expanding one’s operations too quickly. This behaviour occurs when one has too many open positions or has invested a disproportionate amount of capital in a single trade. More specifically, it occurs when there is an excessive number of market operations involving buying or selling shares, or other financial instruments, by a broker or single trader. Overtrading can prove detrimental to your portfolio. Even the most careful traders can end up doing more exchanges than they budgeted for. The issue is different for brokers, as they deal with regulated entities, and they could face very serious consequences by overtrading.

As previously mentioned, overtrading can occur by doing more operations than you should and buying or selling more contracts than necessary. This problem can occur for different reasons, but the effects of overtrading are often the same: poor returns and a higher commission to pay to the broker.

It’s possible to overcome overtrading following the following measures, for example:

• Avoiding emotional reactions. It’s important to distinguish between emotional and rational decisions in trading and to back-up your own decisions with detailed market analyses.
• Diversifying your portfolio. In the event that you have more than one position open at the same time, you can limit the risk by diversifying your investments on different types of assets.
• Only use the resources you have at your disposal. Choose how much you’re willing to risk and never use more money than you can afford to lose.

The advisable solution to avoid this problem is to develop a trading strategy and an effective risk-management strategy. To do all this it is advisable to:

• Set your objectives. What makes you want to trade? It’s important to define your objectives but also to identify the type of trader you want to become. There are four particularly common types of trading: scalping, day trading, swing trading and position trading.
• Set limits on time and money. You need to decide how much time and money you want to devote to trading. In fact, trading requires time to prepare, to get in-depth knowledge of the markets and to analyse financial information. Then, you also need to assess how much money you’re willing to invest into your trading activity.
• Manage risks. You need to define the level of risk you’re willing to take. All financial assets involve risks and to manage them well you need to identify the best risk-return trade-off for you.
• Know the markets. Before you start trading, it’s essential that you get acquainted with your chosen market and that you take note of the most important data.

Still looking at overtrading, the following strategies can also be useful.

The level of risk for each trading operation can range from 1% to 10%, depending on the risk one is willing to take. If the risk is higher than 10%, it could lead to losing 50% of trading capital in just five operations. This is why it’s generally advisable to keep the percentage of risk under 10%. You have to make sure that the risk percentage is sustainable and that you can still reach the trading objectives you set yourself.

H3: Defining the most suitable risk-return trade-off to you

To calculate the risk for a specific operation, you just have to compare the amount of money at risk to the potential return. For example, if the potential loss for an operation is £200 and the maximum return is £600, the risk-return trade-off will be 1:3.