FLASH SALE! - "FINANCIAL MODELING COURSE BUNDLE AT 60% OFF" Enroll Now

Overtrading

Updated on March 27, 2024
Article byRutan Bhattacharyya
Edited byRutan Bhattacharyya
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Overtrading?

Overtrading is the excessive buying and selling of financial instruments, such as stocks, bonds, etc., by an individual trader or a broker. While there are no regulations against individual traders for excessive trading, brokers being regulated bodies may face significant consequences.

Overtrading

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Overtrading (wallstreetmojo.com)

Typically, this practice involves exceeding a particular number of transactions in a specific duration. Brokers overtrade to generate more commission. That said, this practice is illegal for them. Individuals must note that, in some cases, mutual funds and brokerages may have their regulations concerning this practice. Individuals must refrain from excessive trading as it often leads to poor returns.

Key Takeaways

  • The overtrading definition refers to the practice of carrying out too many trades. Individual traders must avoid this practice as they might incur significant losses.
  • Capital market regulators prohibit brokers from engaging in the excessive buying and selling of financial securities. However, there are no restrictions concerning overtrading for individual traders.
  • Some common reasons behind overtrading are greed, over-excitement, and boredom.
  • There are certain things one should remember to avoid excessive trading. For instance, they should know when to take a break. Moreover, one should create a concrete trading rule and remember to control their emotions.

Overtrading Explained

The overtrading definition refers to the practice of buying and selling financial assets too frequently. It may involve spending significant money on a trade or having excessive open positions.

Although it is illegal for brokers to overtrade, they might still do it if they are under pressure to place newly issued financial instruments underwritten by an organization’s investment banking arm.

For instance, every broker may get a 15% commission if they can secure a specific allotment of new stocks for the clients. However, traders can safeguard themselves from this practice using a wrap account. Brokers manage this account by levying a flat fee instead of imposing a commission on all transactions.

Securities market regulators do not prohibit individual traders from buying and selling securities too frequently as the individuals overtrade for their purposes. While one may engage in excessive trading for multiple reasons, the outcome is the same every time: poor return on investments and high brokerage fees. Analyzing various factors, such as taxes, trading laws, brokerage fees, and financial circumstances, can help determine whether their trading volume is too high.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Causes

There are various causes of overtrading in finance. If individuals find themselves overtrading, they must pinpoint the reason why. Identifying the cause enables them to take the actions necessary to trade better. Let us look at some of the reasons:

  • Over-excitement: When prices move quickly, traders open positions without conducting thorough research and analysis.
  • Greed: When traders make profits, they perform more transactions to generate more returns.
  • Vengeance: Traders often engage in excessive trading to compensate for a significant loss or a series of small losses.
  • Boredom: Staring at the screen all day without buying or selling financial instruments can be difficult for some people. They end up placing orders for the sake of trading.

Symptoms

The best part of overtrading is that it comes with certain signs for traders to identify they are too frequently investing in securities and assets.

The following are some common signs of overtrading:

  • An individual is dealing with low-quality trades that are decreasing their returns
  • A trader is buying or selling financial instruments on a lower time frame
  • An individual is buying or selling stocks or other financial securities in a tight range, negatively impacting their profits
  • The trading frequency is counterproductive to the trader’s objective

Effects

Besides knowing the signs of overtrading, one must look at the effects. So, let us look at some of them.

  • One has to pay higher brokerage fees without observable results. 
  • Traders may have to pay higher capital gains tax
  • Individuals may incur substantial losses

Moreover, excessive trading can also lead to an over-leveraged account.

Examples

Let us look at the overtrading examples to understand the concept better.

Example 1

Suppose David purchased five shares of XYZ stock at $50. He sold them the following day when the price dropped to $45. The next day, XYZ stock surged to $55; he purchased five shares again. The following day the price decreased to $51, and David sold them again. As one can observe, David lost both times he bought and sold the stock owing to overtrading. If he had bought the shares at $50 and sold them at $51, he would have made a profit.

Example 2

According to a recent report, overtrading has been cited as one of the major reasons behind the losses that investors incur nowadays. The low brokerage encourages traders to invest more frequently in stocks and other securities, thereby making them vulnerable market players. The random investments reflect their inability to assess the market scenario and keep investing as they have to pay lower brokerage charges. This frequent investing leads to frequent losses.

How To Avoid?

The following are some tips to avoid overtrading:

#1 – Be Conscious Of The Problem

Traders must have their parameters regarding excessive trading and the threshold number. This helps them to look for the tell-tale signs to identify if they place buy and sell orders too frequently. Becoming aware of the issue is the first step.

#2 – Make a Concrete Rule 

Individuals should consider making concrete trading rules to keep their trading behavior under control. For instance, traders can create a rule that they will only place up to three buy or sell orders in a trading session.

#3 – Keep Emotion Under Control

Emotions like greed, fear, and vengeance can cause traders to make the wrong decisions, leading to significant losses. Hence, one must create a well-defined trading plan and stick to it to fulfill their objective.

#4 – Know When To Step Away

When traders realize they are approaching the excessive trading phase, they must consciously step away from the market. A cash position and a clean break from securities trading help one to regain control. This is a crucial skill and one of the most difficult ones to learn.

Overtrading Vs Undertrading

To fulfill their objective quickly, undertrading and overtrading in finance are practices that an individual would want to avoid. However, the two terms can confuse traders new to the securities market. Therefore, understanding the critical differences between the two practices is vital to strike the right balance. So, the table below highlights their distinct characteristics to help one get a clear idea of the two concepts.

OvertradingUndertrading
It involves brokers or individual traders buying and selling financial securities too often. Undertrading involves hardly any trading activity, even when traders have enough opportunities to trade in the market. 
Traders use their funds too frequently and have many open positions.  Individuals do not utilize their funds often and have very few open positions. 
Greed, vengeance, and overexcitement are some of the causes of overtrading. The primary cause of undertrading is the fear of losing funds. 

Frequently Asked Questions (FAQs)

1. What are the characteristics of overtrading?

The characteristics of overtrading are as follows:
– Traders use their money too frequently to buy financial instruments. 
– Individuals do not have strict entry conditions and have too many open positions. 
– Traders rush to make wrong decisions owing to emotions like fear, greed, and vengeance.

2. How many trades is overtrading?

The practice of excessive trading involves placing too many trades. That said, the definition of ‘too many’ varies from one trader to another. There is no fixed number. The answer depends on multiple factors, for example, the individual’s trading style, knowledge, experience, and specialization. For instance, placing 40 buy and sell orders might be manageable for one trader, while another individual might not be able to carry out more than ten trades.

3. What is overtrading in business?

Overtrading in business occurs when organizations accept work but realize that they need more financial resources, for example, cash, to complete it.

4. How can a business prevent overtrading?

Businesses can take the following measures to prevent it:
– Encourage automated payments
– Improve their inventory control
– Offer discounts to receive payment on time
– Set new payment terms

This article has been a guide to what is Overtrading. Here, we explain how to avoid it, its symptoms, examples, vs undertaking, causes, and effects. You may also find some useful articles here –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *