What Is Overtrading and How to Avoid It?
Investment, by its very nature, involves risk, and the stock market – mirroring life itself – can present unexpected challenges even to keen financial observers. However, losses often stem not just from the unpredictable turns of the market but also from traders’ missteps. These include a lack of market knowledge, inconsistency in trading approach, or overtrading – a major trading sin that, thankfully, can be avoided. Here’s how!
What Is Overtrading?
Overtrading is a term used when a trader makes too many trades in a short amount of time, often because he’s reacting to his emotions rather than making decisions based on careful analysis. It’s as if someone were trying to win a race by sprinting the entire time without pacing themselves; eventually, they run out of steam and can’t keep up.
This behavior can lead to several problems. First, it often results in the trader not fully considering the risks of each trade, leading to poor choices that can cause big financial losses. Each trade comes with its own set of risks, and without taking the time to evaluate these risks properly, the chances of losing money increase significantly.
But the issues with overtrading don’t stop at losing money. Overtrading can easily take a toll on the trader’s mental and physical health. Constantly being in “trading mode” can lead to stress, anxiety, and burnout.
Why Traders Overtrade?
So why do people overtrade? Ari Kiev, a psychiatrist who specializes in stress management and works with traders, suggests a few possible explanations in one of his book “Trading to Win.” These include:
Seeking Involvement: Some traders overtrade because they feel the need to always be active. They believe that being an active trader means making trades throughout the day. This belief can make them feel left out or like they’re missing opportunities if they’re not constantly trading.
High-Performance Goals: Other traders set very ambitious performance goals for themselves. They think that the only way to achieve these goals is by making numerous trades. This is particularly true for professional institutional traders who are under pressure to make profits to maintain their employment. The fear of not meeting performance objectives can drive them to make more trades in an attempt to show progress, often leading to losses.
Personality Traits: For some traders, their personality drives them to overtrade. Those with an impulsive nature might find excessive trading exciting. Others might trade too much as a way to cope with frustration in their lives. They hope each trade will be the one that brings success and fulfillment.
Dr. Brett Steenbarger – a long-time coach and recruiter of traders, as well as the author of several books in this field, including Trading Psychology 2.0 and The Psychology of Trading – draws attention to daydreaming as one of the reasons for overtrading.
Traders might daydream about making big wins to feel a sense of power and control, which is hard to achieve in an unpredictable market. Believing in these daydreams can lead them to make unrealistic trades, thinking that success is just a matter of trading more, which can end in losses.
Other reasons may include:
Lack of Patience: Impatience can drive traders to overtrade as they seek quick profits and become frustrated with the market’s unpredictability.
Fear of Missing Out (FOMO): FOMO can compel traders to enter trades without clear signals, driven by the worry that they might miss out on profitable opportunities.
Emotional Attachment: Developing an emotional bond with trades can make traders overly reactive to minor market fluctuations, leading to impulsive and often detrimental decisions.
Addiction: The thrill and adrenaline rush of trading can be addictive, making it hard for some traders to stop even when it’s not in their best interest, similar to the dynamics of gambling addiction.
How To Stop Overtrading?
In the fast-paced world of trading, it’s easy to get caught up in the excitement and make impulsive decisions. However, by understanding the importance of discipline and implementing effective strategies, you can break free from this cycle and achieve long-term success. Here are six essential tips you can implement to avoid the trap of overtrading:
1) Recognize Overtrading: The first step in avoiding overtrading is to recognize when it’s occurring. Be mindful of the frequency and volume of your trades. Reflect on your motivations and emotions behind each trade. Acknowledging that you may be overtrading is crucial before you can take corrective action. Remember, every trader has different reasons for overtrading. Some of them may include a lack of proper preparation, insufficient trust in trading plans, or impulsiveness. Identifying personal factors is essential for developing effective strategies to mitigate overtrading.
2) Develop a Trading Plan: Before you put on a trade, make sure your trading plan is clear. Begin by defining the signals or indicators that will guide your trade monitoring process. It’s crucial to anticipate which indicators might signify a trade moving unfavorably. Additionally, thoroughly justify your trading plan by ensuring you have solid reasons supporting each trade decision.
3) Exercise Self-awareness: Regularly assess your trading activity to identify patterns that suggest overtrading. Look for progressive increases in the number of trades each month as a sign of potential overtrading. Being aware of these patterns allows you to take corrective action before it becomes a significant issue.
4) Take a Break: If you find yourself feeling pressured to make trades, take a break from trading. Stepping away allows you to reassess your strategies and ensure they align with your overall investment objectives. This break provides valuable time to reflect on your decisions and avoid impulsive trading.
5) Create Rules: Establish clear rules for entering trades based on technical or fundamental analysis. These rules act as a framework to guide your trading decisions and prevent deviation from your trading plan.
6) Commit to Risk Management: Prioritize strict risk management practices, including position size management. By managing risk on individual trades, you can mitigate the likelihood of significant drawdowns, reducing the psychological impact of losses. Consistently applying risk management techniques will help you maintain discipline and avoid overtrading.
Conclusion
Overtrading, driven by emotions rather than strategic analysis, can lead to significant financial losses and take a toll on traders’ mental and physical well-being. Understanding the root causes behind overtrading – whether it’s the need for constant activity, high-performance goals, personality traits, or other factors – is essential for implementing effective strategies to mitigate this risk.
By understanding the consequences of overtrading and implementing effective risk management strategies traders can avoid falling into the trap of overtrading. These steps not only help to safeguard against financial losses but also promote a more balanced and sustainable approach to trading, ultimately leading to greater long-term success in the stock market.
